Sunday, August 26, 2012

Markets Determine Interest Rates...Until The Fed Says Otherwise

About a month ago JW Mason of The Slack Wire asked, Does the Fed Control Interest Rates? This was in response to some back-and-forth regarding the effectiveness of monetary policy. Previously on this blog, I’ve outlined my view that interest rates are determined by expectations about the future path of monetary policy (see here, here and here). In this sense, the Fed does, to varying degrees, control interest rates across the curve. Mason attempts to dispel that view, in part, with the following chart showing the rate structure against moves in the Fed Funds rate:
His conclusion is:

Wouldn't it be simpler to allow that maybe long rates are not, after all, set as "the sum of (a) an average of present and future short-term rates and (b) [relatively stable] term and risk premia," but that they follow their own independent course, set by conventional beliefs that the central bank can only shift slowly, unreliably and against considerable resistance? That's what Keynes thought.
So apparently the Fed doesn’t control interest rates. Well, hold on a moment. Not long after Mason’s post, The New Arthurian Economics responded with But why, JW? Why "The past 25 years"?? As you’ll note, the above chart only considers rates back to 1987. Using some clever data mining and chart altering, Art comes up with the following historical look at the Fed Funds rate versus an average of other market interest rates:
Once again, it appears that rates are not following the Fed as closely as one might expect.

Responding to both Mason and Art, in the comments, I offered my own answer to the question. In short (you can read the full comments if you choose), market expectations of future Fed action are sticky. During the post-war period until about 1980, inflation was consistently rising despite mainstream economic views that suggested those conditions would not persist. Following a lengthy inter-war period of near rock-bottom interest rates, market participants were slow to adjust expectations to the actual height of interest rates that would occur before sustained disinflation began. Once disinflation began in the early 1980’s, market expectations were equally slow in recognizing how long disinflation could persist and therefore how low the Fed would ultimately take rates (and hold at zero).

Contrary to this expectations based view, Jazzbumpa, of Angry Bear, countered with a link to his previous post on Who Determines Short Term Interest Rates? His conclusion, supported by various graphs:

The Federal Funds Rate, which is set by the Fed, FOLLOWS 3 month T-Bill rates.  It does not lead the economy.
This leads to two important questions on the subject:
1) Does the Fed have any real power to influence interest rates?2) What would happen if they attempted to move counter to the market?
These questions have plagued me for the past few weeks, but I think I’ve found the answer.

As I pointed out in one my comments:

The Fed acts in certain intervals and operates under a corridor system. In this manner, the Fed sets the target rate but permits fluctuations within a band between the discount rate and IOR rate.
Now let’s imagine that during an interval between FOMC meetings, private credit expansion is causing banks to demand more reserves. Absent open market operations that increase the supply of reserves, the Fed Funds rate will move higher towards the upper bound of the targeted range. Witnessing this change, the Fed can choose to respond by either expanding the supply of reserves to maintain its current policy rate or by raising the rate to match the “market-determined” interest rate. The same principle would apply in reverse to a decline in demand for reserves. In this manner, the Fed FOLLOWS the market in supplying reserves and setting the Fed Funds rate.

Not surprisingly, the story above complements the paper by Scott Fullwiler “Interest Rates and Fiscal Sustainability”, which notes:

“More recently, Fullwiler (2003) and Lavoie (2005) have demonstrated that the central bank’s obligation to promote the smooth operation of the payments system means that the provision of reserve balances are necessarily non-discretionary. (p.12)”
After much thought, I’m willing to concede that the Fed primarily acts (or has acted) passively in setting short-term rates. This view, however, does not entirely undermine the expectations theory for long-term interest rates or the Fed’s ability to control interest rates. If market participants are aware that the Fed reacts to market moves, then future expectations regarding a “market-determined” interest rate provides a reasonable proxy for the Fed Funds rate. Separately, the Fed could announce a ceiling on long-term Treasury rates and dare the market to test its resolve. Therefore, I accept that in practice the market determines interest rates, but retain the view that operationally the Fed could control interest rates.

A real test of the Fed’s power to manipulate interest rates would require the Fed to either act counter to the market or cap specific rates along the curve. Although the latter seems more likely than the former, I don't expect either action to occur anytime in the near future. Considering central banks outside of the Fed, the ECB may soon provide a real-world experiment by setting a ceiling on rates. Though the EMU holds stark differences with the US monetary system, it will be enlightening to witness a central bank truly take on the markets. This debate is far from over...   


  1. Note the difference between suggesting that the Fed can set rates where it wants and whether or not it does. It most definitely CAN set the rate given that it has an unlimited capacity to purchase, or that it can enter into any market of any maturity and offer to borrow/lend at a rate (or a spread, where applicable) that it names. Obviously, aside from the fed funds rate it hasn't chosen to actually set a rate directly.

    Nonetheless, I still think that the expectations framework with a premium and a few technicals (convexity, etc.) explains long-term Tsy's the best (and obviously there are some other factors at work in the non-Tsy markets)--and Kregel has shown a few times this is quite consistent with Keynes--not to mention that finding that the fed funds rate lags the tbill is exactly what the expectations theory would say happens (tbill's a longer maturity, after all). (Note also that in your graph, the only time there is a significant difference b/n fed funds rate and longer rates (and I don't know if the longer rates are only Tsy's or not, and if not then the point is moot) is before the early 1950s, during which time the Fed did directly set long-term Tsy rates until the Tsy/Fed Accord relieved the Fed from this duty.)

    Regarding the fed funds rate, one must recognize that there is no role at all of price discovery in the market for central bank balances--this is not a controversial point at all in the literature on the details of central bank operations. So, even if it is the fed funds rate following the lead of the tbill, it's because the Fed chooses to do it that way (and it wouldn't surprise me if that were how the Fed made its choice, but that doesn't mean it has to).

    Scott Fullwiler

  2. I agree with Scott F.'s first paragraph. It's important to distinguish between the capability of central banks *in principle* to control interest rates on debt denominated in their own currency, and the extent to which conventional monetary policy has actually done so.

    I am not sure about the second paragraph. In particular, while I'm not sure what specific article of Kregel is being referred to, I think the claim that Keynes believed that the central bank could control market long rates by setting short-term risk-free rates is unambiguously false. in fact, the relative inelasticity of long rates with respect to the policy rate was central to Keynes' thought, and arguably *the* motivation for fiscal policy in his theory. I follow Leijonhufvud in this, but it's enough to read Keynes.

    I agree that central banks can in principle exercise much more control over the whole rate structure than they have historically done in practice. (Except in wartime, when the problems are different.) And that more influence wouldn't come without costs. I suspect that there is a floor on long rates -- perhaps not so much lower than current rates -- that if the Fed wanted to lower rates below, given the current institutional structure of the financial system, it could only do so by displacing all private intermediaries from the credit market, i.e. by buying up essentially all private debt.

  3. (in other news the anti-spam filter here almost defeated my human pattern-recognition capacities. On my own blog I don't use these, I just accept that part of my job as blog-owner is to delete occasional spam comments.)

  4. STF and JW - Thanks for the comments...your input is greatly appreciated! (Also, I have removed the filter).

    Unfortunately I am not enough of an expert on Keynes to know which way he leaned on this issue. If I'm not mistaken, I could envision a middle ground whereby Keynes believed that long-run functioned based on short-term expectations but were highly "sticky down." This would imply ineffective monetary policy during times of crisis and the motivation for fiscal policy. (Hopefully I haven't completely misinterpreted each of your views).

  5. "I think the claim that Keynes believed that the central bank could control market long rates by setting short-term risk-free rates is unambiguously false."

    Not what I said. What I said was that the expectations theory as I suggested should be adjusted (term premia plus technicals like convexity, etc.) is a good explanation of long-term Tsys (Mason's graph has far more than that as it includes non-Tsys) is consistent with Keynes (I said "quite consistent" but more appropriately should have said at least partly consistent--apologies for that, as Keynes's explanation was more conditional and his TOM was also written in a gold-standard setting). Note that there's nothing in there that should suggest I argued that "the central bank could control long rates by setting short-term risk free rates."

    "in fact, the relative inelasticity of long rates with respect to the policy rate was central to Keynes' thought, "

    Again, that's conditionally consistent with the expectations approach I'm suggesting, at least for long-term default risk free.

  6. Bad economic conditions is getting worse because of Obama monetary policy as discussed by Ed Butowsky in Fox Business.

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