Who Determines Short Term Interest Rates?

Do you think it’s the Fed?

It’s not.

The market determines short term interest rates.

Really.

The Federal Funds Rate, which is set by the Fed, FOLLOWS 3 month T-Bill rates.  It does not lead the economy.  Here are some looks.  First the whole data set, going back to 1954, presented in Graph 1.

Federal Funds data from FRED.

T-Bill rates from a different Federal Reserve site

These are tabulated monthly values.  But the T-Bill rate is set in a weekly auction, and the Fed Funds rate is set by the Fed Open Market Committee, on an arbitrary schedule, at their discretion. 

Graph 1  Fed Funds and 3 Mo. T Bill Rates, 1954-2011

Not exactly lock step, but they are a couple of clinging vines.  At this scale, it’s pretty hard to tell who leads and who follows.  Let’s look closer at the last few decades.  First, the all-time highs of the early 80′s, in Graph 2.

Graph 2  Fed Funds and 3 Mo. T Bill Rates, 1978-84

Here, the Fed Funds are in green and the T-Bill rate in orange, with the moves off of tops and bottoms highlighted in other colors.  Fed Funds tend to run a bit above T-Bills.  From this data, T-Bill rates generally change direction in the same month or the month prior to a Fed Funds change.

Graph 3  Fed Funds and 3 Mo. T Bill Rates, 1978-84

Same story in Graph 3: either concurrent motion or T-Bills are slightly ahead.  For the two downward moves at the beginnings of 1990 and 1995, they are three to four months ahead.

The story is similar for the most recent decade, shown in Graph 4.

Graph 4  Fed Funds and 3 Mo. T Bill Rates, 2000-2008

Looks like the Fed is a close follower of T-Bill rates, usually within a month or so.  Coming off a diffuse top, the lag can be a little longer.

Graph 5 shows a close up of 2001-5, without the odd colors.  T-Bill leadership is easily seen.

Graph 5  Fed Funds and 3 Mo. T Bill Rates, 2001-05

Two questions present themselves:

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?

In my mind, this casts serious doubt on the usefulness of interest rate manipulations as a monetary policy lever.   What do you think?
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