Tuesday, January 2, 2018

Fed Policy and the Market

As the (red line in the) below chart shows, the US Federal Reserve is embarking on a new policy to lift interest rates gradually back to normal levels. Today's post suggests that even if the Fed keeps to its goal of raising the Federal Funds rate gradually in the coming year, the Fed might not get what it is hoping for.

To convince you that this is no slam dunk (to raise market interest rates), it takes a little excursion into interest rates and then a closer look at the below graph.

Let's start with interest rates. There are many interest rates out there, and the Fed has no direct control over them. You can think about an interest rate in two ways -- as a saver or as a borrower. When you put your life savings into your money market account, you soon learn that with today's low interest rates you get enough return to buy yourself maybe 15 minutes on a Bloomington parking meter. If you instead lend the money to the government by buying a long-term government bond, you might get an interest rate of about 2.8%. That means if you buy a bond for $100, you will get back the sum of $2.80 each year you own the bond. That return amounts to a coffee of the day at Peet's. No refills.

You might instead want to borrow money. Most of us borrow for a car or a home or a month's supply of JD. In that case, you would pay the interest rate on a car loan or mortgage rate or whatever rate your friendly credit company charges.

Whether a saver or a borrower, you experience interest rates, and the fact is that interest rates are not set by the Fed or the government or even Santa. Interest rates, prices of stocks and peanuts, respond to market forces. If in today's market everyone wants to borrow and no one wants to lend, this tends to raise interest rates. If tomorrow most people are interested in lending and there are few borrowers around, then interest rates fall. We say interest rates are mostly market driven.

A quick look at the blue line (interest rate on a government bond with a 10 year maturity) in the graph below shows you that interest rates have a pretty exciting life. And this graph only shows you 1999 to present. A graph going back to the 1960s would make your head swim. Remember those 20% interest rates in the 1970s?

Okay, so rates are determined by market forces. Where does the Fed come in? Like most government entities, the Fed likes to try to make the world better. The way the Fed does this is to try to raise interest rates when the economy is acting like a runaway train car. Or when the economy gets slow and creepy, the Fed tries to stoke it with lower interest rates.

I keep saying "tries" because the Fed does not tell banks and other financial institutions how much to charge on auto loans or mortgages. But the Fed can try to influence these rates through its control over something called the Federal Funds Rate (FFR). The Fed sets goals for the FFR and can reach those goals by intervening in something called the FF market where bankers loan each other money on a  daily basis. It's too long a story for the blog today but just take it for granted that the Fed can take actions which either decrease or increase the FFR.

The FFR is the red line below. A quick review: the Fed altered policy several times since 1999, first raising the FFR, then reducing it only to raise it again. It bottomed out at the end of 2008 and was kept near zero until recently. November 2015 marks a turning point in which the Fed started raising the FFR. We are told that since the economy is now humming along at about 70 miles per hour, they need to raise rates to cool things off a bit. Plans are to increase the FFR several times into 2018.

Why raise rates? Presumably because a near-zero percent interest is not normal and it tends to penalize savers. Some think it might make savers want to take on too much risk by buying bitcoins or 8-track players. Whatever the reason, the goal today is to raise the FFR. The goal is to have the rise in the FFR spillover and influence all those other market rates. The chart below is instructive in that regard. We can look at the relationship between the FFR and the interest rate on government bonds with a 10-year maturity (I chose this one market rate because there are just too many too choose from and this one has the reputation of being a good indicator of what is happening to most rates.)

Notice in the chart that increases in the FFR do not always result in higher interest rates.
  • After 1999, the FFR increased to almost 7% while the 10-year rate started to rise but then fell.
  • After 2004, the FFR went from 1% to over 5% yet the 10-year rate bobbed up and down like a tuna in a shark tank and ended up only a smidge higher than it has been in the recent past.
  • After 2016, the FFR gently increased while the 10-year rate's downward trend was only interrupted in 2017. But notice that the 10-year rate today remains below its peak value in 2014 and is well below other previous peaks.
Since you are still a bit slow from your New Years' partying, I will refrain from taking this much further. But the obvious question to ask at this point is why the 10 year rate has been so fickle. It is supposed to do what the FFR tells it to do. The bottom line is that market rates are impacted by many things -- psychological and other -- and only one of those many things is the level of the FFR. The chart shows how important markets are to interest rates and why it is possible that Fed policy may not succeed in its goal to protect the US economy from immodest growth. Worth speculating about at George and Wendy's is the long-term downward trend observed in the graph. The 10-year rate has been on a downward slope for about 17 years. I wonder what it will take in the way of Fed policy to reverse that.

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