The game will be well into the first half before the Fed gets on its uniform!

Who Controls Interest rates? The Fed or the Market?

Since we are spending so much time oohhing and ahhhing about the Fed, it isn’t a bad idea to get into some arcane but straight forward realities about interest rates.

The markets were so happy to hear on Tuesday that the Fed is NOT going to raise interest rates yet. A collective global sigh was heard as we learned that the economy is still too soft to withstand tighter money and higher interest rates. The price of gyros firmed in Athens!

But does the Fed really control interest rates? It depends on which rates you mean. Does it control mortgage rates? Rates on business loans? Rates on commercial paper? Car loan rates? No, No, No, No. Hmm – so what does the Fed control?

To make a long story short, the Fed directly controls the discount rate – the Fed can “dial-up” a higher discount rate easily. The discount rate is what the Fed charges when it lends money to commercial banks. Second, it controls the target rate for something called the federal funds rate (ffr). I say it controls the target because the ffr is really a market rate driven by the supply and demand for short-term funds that commercial banks lend to each other. If the Fed decides on a higher ffr target than exists today in the fed funds market, it will sell part of its bond holdings, essentially draining liquidity out of the banking system. As funds become scarcer, the usual buying and selling of federal funds will generate a higher ffr. If the Fed hits its target rate– and it usually does – it really sets the ffr (and not just the target). To summarize – if the Fed wants to lift the ffr to 1.0% , it would sell some bonds and watch the market ffr rise. When the market rate rises to 1% then the Fed will know it sold enough bonds. Viola!

So the discount rate and the ffr are about the only rates the Fed really controls. That is worth knowing – especially in this environment of wondering when the Fed is going to begin its drive to increase interest rates. The main point is that when it comes to car loans and mortgage loans, and various other financial transactions, the interest rates are set by the interplay of supply and demand. While the Fed’s actions are part of the supply and demand and the Fed’s decisions influence these markets, they are by no means the only factor to impact these and other interest rates.

For example, we know the Treasury needs a bunch of money. So they are selling a wagonload of bonds each month and will be doing this for quite some time. As the economy recovers in the coming year we expect demand for houses, cars, business equipment, Jack Daniels, and many other items to increase. This means that more and more households and firms will be borrowing – taking out banks loans and selling bonds. Even without any change in the Fed’s monetary policy there will be a cyclical reason, therefore, for interest rates to rise as more and more borrowers compete with each other for a given amount of funds.

So rates can rise even if the Fed’s policy is unchanged. Now here is the fun part. Let’s suppose the Fed does NOT want the rates to rise – what can it do? Keep in mind that one of the market rates that might begin rising is the ffr. If the Fed has a goal to keep the ffr no higher than 0.25%, then it will have to PEG THE MARKET RATE AT THE TARGET RATE – which means supplying more liquidity to the market. Notice that when the Fed tries to peg the ffr rate in the face of rising loan demand – this means injecting even more liquidity into the banking and economic system. THIS MEANS INJECTING EVEN MORE MONEY AT A TIME WHEN THERE IS ALREADY MUCH TOO MUCH MONEY IN THE SYSTEM. THIS MEANS THAT THE JOB OF REMOVING THE LIQUIDITY AT THE MAGIC MOMENT BECOMES EVEN HARDER AND THE RISK OF HIGH INFLATION GETS BIGGER.

Okay so the money supply grows but what about the interest rates? It is hard to say. The Fed might try to prevent the ffr from rising but if the market knows that fundamental factors are driving interest rates upward, then the pegged ffr might not reduce the pressure on the other rates. And if the risk of future inflation is truly perceived to be higher – this too will add to interest rates today.

Hmm – so is the Fed or the market driving the interest rates? My guess is that in the coming year, Fed policy will be a lagging indicator of interest rate change. Once the Fed does announce a policy to tighten money and withdraw liquidity, the rates will have already risen and the ffr and discount rate will come in line with the rates that have already risen….Upshot – keep your eye on the markets. The game will be well into the first half before the Fed gets on its uniform!