The Fed, like many other central banks, have an inflation target. Thanks to TIPS spreads, they get a market forecast of inflation.
Thus the Fed could just buy and sell treasuries in the open market until the TIPS spread is at their inflation target.
As a by-product those open market transactions will increase or decrease the quantity of reserves. Without any need for the Fed to even think about interest rates.
Practical example next: Singapore's central bank also cares about inflation. Instead of mucking around with interest rates on bonds, they muck around with foreign exchange rates by buying and selling forex on the open market.
Interest rates on government debt are left to the market. (Just like in the Fed system, foreign exchange rates are left to the market.)
For a big country, directly buying and selling forex might be seen as 'evil currency manipulation'. But the system would be just as workable if they used eg a basket of commodities or even some broad ETFs instead.
(Historically, a basket consisting of a single commodity, gold, used to be rather popular. But that's a different story.)
>>"As a by-product those open market transactions will increase or decrease the quantity of reserves. Without any need for the Fed to even think about interest rates"
But changing the interest rate in the process.
You are implying that the TIPS spread is a better indicator of inflation that the interest rate. That doesn't make a lot of sense to me. More important, doesn't make sense to the central bankers, because they target the interest rate not the TIPS spread.
Huh? TIPS spreads are literally market inflation expectations. Obviously they are amongst the best indicator of future inflation we have.
(Other indicators the Fed uses include internal forecasts.)
Nobody thinks that interest rates are a good indicator of inflation. Certainly no one at the Fed. Or, what do you mean by 'indicator'?
The Fed wants to keep the price level on a stable trajectory, and they use an interest rate target as an intermediate instrument to do so.
An instrument is a very different concept from an indicator, in my understanding. It's like the accelerator pedal vs the speedometer. Do you use the two terms in a different way?
> But changing the interest rate in the process.
Yes, but as a side effect. Just like the Fed actions also influence the exchange rate or the price of gold, but neither of the two is their target nor instrument.
>> "An instrument is a very different concept from an indicator"
You are right there.
>>"The Fed wants to keep the price level on a stable trajectory, and they use an interest rate target as an intermediate instrument to do so."
Yes, they use it like the main instrument to do so. And that's the reason why they can't just allow the interest rate to float freely. And because they can't allow the interest rate to float freely they have to add reserves when the inter-bank market is going up. So, reserves will be added to the system when banks need them.
Using interest rates as a policy instrument is a decision they make. Technically, It would be rather easy for them to change that decision and eg just buy and sell t-bills directly without any reference to interest rates.
They can easily choose to let interest rates float freely.
Of course, even if they directed targeted eg the TIPS spread without worrying about interest rates, in the end they would still add reserves when banks lend. (Ceteris paribus.)
