Does the Fed Control Interest Rates?

Strong statements about the effects of Federal Reserve actions on interest rates are common in the media and among academics. I’ve long been puzzled by such claims since the Fed seems to be a minor player in financial markets. In recent years total U.S. credit market debt, as reported in Federal Reserve Flow of funds tables, is in excess of $50 trillion. Prior to the financial crisis of 2008, total financial assets held by the Fed are less than $1 trillion, or less than two percent of the U.S. market. In response to the financial crisis of 2008, total financial assets held by the Fed jump to over $2 trillion and are almost $2.5 trillion at the end of 2010. This is huge by historical standards, but still less than five percent of the U.S. market. Many large banks (e.g., J.P., Morgan Chase, Bank of America, Citibank, Wells Fargo, etc.) have balance sheets comparable in size to the Fed’s. Moreover, the U.S. credit market sits in a large international market that is open to major market participants (governments and large private firms, financial and nonfinancial) around the world, and the big players can and do operate across markets. In this context, it may seem implausible that the Fed has more than a minor role in determining interest rates, except to the extent that it can affect inflation expectations. It seems even more implausible that in an open international bond market, multiple central banks can separately control interest rates in their local markets.

That is from a new paper by Eugene Fama.