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.
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.
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.
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.
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.
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?
.
jazz
i don’t know enough about it to “think.” but again, according to Greider, and he’s pretty detailed, the Fed was sure trying to set interest rates throughout the seventies and early eighties, depending on the prevailing economic wisdom of the time. i am not sure the ‘oo changed what rate first gets at the actual dynamics.
like i said, i don’t know, but i’d be careful before drawing any conclusions from this data.
Dale –
That’s why I end with questions rather than conclusions. But the Fed trying to do something is not the same as actually accomplishing it. By following, they institutionalize market behavior, and that might have some value in a policy context, maybe?
But in real nuts and bolts terms, if the market sets rates, what is the Fed’s actual roll, and what power does it really have?
Cheers!
JzB the skeptical trombonist
jazzbumpa,
The Fed does “set” interest rates. One can see interest rates move as soon as the Fed Chair says “we’re gonna push rates up” (or down). That said, the Fed doesn’t have absolute control. The Fed may want to reduce interest rates, but if its behavior is causing people to anticipate a lot of inflation coming down the pike very soon, the Fed won’t succeed.
I think the best way to think about it is to assume there is a market, but the Fed, by being the biggest player, is also the biggest influence on outcomes.
jazz
i think you… and kimel… are right that the Fed does not succeed, at least that was their excuse when interest rates kept running away from them while they tried to control the money supply.. without knowing what “money” is (as new forms of “money” emerged in the seventies).
On the other hand, the end result was favorable to the bankers and bond traders, so a deeply cynical person might suspect their right hand did not know what their left hand was doing. Bad left hand! Bad! Bad!
My first thought is the possibility that neither causes the other, but both are caused by other factors. The lag might reflect bureaucratic inertia on the part of the Fed. Financial markets move quickly. It is also possible that the Fed considers the market in making their decisions. Not that it follows the market, but that the market provides evidence of what other people think.
Another possibility is that the markets are correctly anticipating the actions of the Fed. Certainly that is the story of financial reporters, for what that is worth. 😉
Min –
Puting your comment together with Mike’s, above, makes a coherent picture, if the Fed is telegraphing their next move. Is that what happens? I really don’t know.
Sometimes, I suppose the next move might be obvious, even to a relativley casual observer. But the markert’s record for anticipating (or at least being coincident with) the Fed is perfect.
Cheers!
JzB
Hence the word “sinister!”
JzB
Consider the T-bill market as a game of trying to predict what the Fed is going to do.
They react to the same data at higher frequency.
For analysis, look for instances where it failed. From your graphs, I would say a number of buyers in mid-2004 misjudged. They thought the fed would jump sooner and farther. Most guessed correctly.
They overshot in 1982. They undershot in 1979.
I don’t know if it is right, but I’m not sure you could tell the difference from the data.
“The Federal Funds Rate, which is set by the Fed, FOLLOWS 3 month T-Bill rates. It does not lead the economy.”
Here we go again. 😉
No, the Fed does set the Effective Fed Fund rate (the rate at which banks borrow/lend their reserve balances amongst themselves). It does so by two-and-a-half mechanisms:
1. The discount window “prime” rate (don’t confuse this with the prime mortgage rate; it’s different) at which they’ll lend to “distressed” banks (with appropriate extra scrutiny).
2. The open-markets desk buying and selling treasuries.
2.5. Expectations management about what [1] will be and what [2] will do.
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Before the Fed makes an announcement, the players in the primary-dealer market are all trying to second-guess each other (and the Fed) in trading T-bills. If the consensus is “lower”, the T-bill rate goes lower, etc. They’re generally pretty good (especially, given [2.5]).
But, if the fed says “3%” and the market says “2.5%”, then the open markets desk will move in, selling T-bills (for cash) until the banks don’t have enough cash in their reserves and the interbank reserve lending rate (FF) goes up. (Or vice versa.)
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One other thing: the Fed can also control what Krugman would call “long” rates (I’d call them “medium”; 2-3-5-years) by announcing for how long it’s going to hold the target rate at a particular level.
For example, if the Fed is credible and says “rates are 0.25% until 2015”, then 3-year bonds (which are exactly equivalent to a reinvested series of 6-month bills), will, due to arbitrage, move to yield exactly the same value.
I should also add that should a bank want to hedge its FF exposure, there are futures:
http://www.cmegroup.com/trading/interest-rates/stir/30-day-federal-fund.html
There is a bit of telegraphing… but not in the sense that you’d think. As I noted above, if the Fed chair gives a speech saying “we’re planning to lower interest rates” generally that’s enough to get the interest rates to start moving down.
That said, the Fed holds meetings at each of the Fed’s regions. A buddy of mine used to attend those meetings in one of the regions as the FDIC representative. As he described the meetings to me, essentially the Fed dude gets up and says something like: “We think it would be nice if credit got tightened up, particularly in the agricultural sector.” The message came across loud and clear.
There are layers of complexity here as well as stipulations about eras. The Fed can’t lean agsnst the wind long term, never haa, but as time has gone on they, and their other Central Bank friends more and more deterine the wind speed with their massive balance sheet expansions.
Everyone says and most believe the Fed ‘sets’ rates, The day most don’t believe it anymore the system will dislocate. The Feds power has become like our founding myth. Nobody in power will ever, ever, question it. Which produces a self fullfilling aspect to all this.
Cameron –
I am perfectly willing to be wrong, but you have to construct a better narrative.
First I say the Fed sets the Federal Funds rate, and you disagree, saying the Fed sets the fed funds rate, so right off the bat, I’m confused.
1. The prime rate, so far as I can tell, is determined by consensus of large banks, and as a rule of thumb is Fed Funds target rate + 3%. If you mean something else, I’m not finding it. Barring that, setting the discount rate de facto sets the prime rate, so we haven’t obtained anything new.
2. Unless the Fed is make large moves specifically in 3 mo T Bills, (and thereby distorting the market) open market buying and selling will have only indirect influence on short interest rates, by effecting reserves. They will perhaps nudge the market into a preferred direction; which can then be confirmed by setting a corresponding fed funds rate.
This is nudging the market, but it is still the market that is setting the 3 mo. t-bill rate.
2.5 If the fed did not closely follow with the fed funds rate change, it would lose credibility (or the signals would be confused) and expectations management would fail.
So the answers to my first question is –
1) Yes, but only so long as they maintain credibility, by being a close follower.
Where have I gone wrong?
JzB
Hmmmm.
It looks like Scott Sumner agrees with me, though I might have that backwards.
http://www.themoneyillusion.com/?p=13706
JzB
I think it is a combination of “the next move is obvious” based on the historical policies of the fed, fed members receiving input from the market, and fed members implicitly or explicitly leaking their intentions.
I also think that there is a strong possibility that a majority of the members actually directly leak information to dealers creating an inside trading opportunity.
Mike Norman economics picked up this post, and one commenter says that Cameron has it right.
http://mikenormaneconomics.blogspot.com/2012/05/who-determines-short-term-interest.html
Another adds:
Many believe this but it’s the other way around. The tbill is based on expectations of the Fed since it’s a 3 month rate and there can be a change in the funds rate that would affect holding period return. Just because statistically one comes first doesn’t mean that’s the causation. They should go read the Fed’s transcripts and see how many times they say “the Tbill’s moving so we have to change the funds rate.” Doesn’t happen.
My response there:
I’m firmly in the time-travels-in-one-direction camp. If A precedes B, anyone who claims B causes A has some serious ‘splainin’ to do. Cameron’s rebuttal of my Angry Bear post consists of some hand waving about prime interest rates and assertions about open market operations and expectations.
Unless the Fed is either making big moves specifically in 3 mo. T Bills, this is attempting to stage manage short rates via winks, nudges, and hints; then following up with a confirmation by adjusting the Fed Funds rate a week, month or quarter later.
If this fits your definition of the verb “set,” then we are not reading the same dictionary.
Another possibility is that the Fed has a pretty keen idea of which way the head winds are blowing, and tries to keep its words and actions consistent with that knowledge. And in doing so, it is a close follower. Data supports this view.
I don’t believe in time travel, but I do believe in Occam’s razor.
Note also, as I pointed out in the A B post, that the biggest delays in Fed following T-Bills occur when there is a major change of direction. That is when Fed perception of the prevailing wind is least certain and they are the slowest to catch up.
I’m always perfectly willing to be proven wrong, but that requires actual proof.
Also, see Scott Sumner on this issue.
Cheers!
JzB
To narrow down this notion of the Fed as the biggest player, the Fed is the only player in the US$ market with near infinite resources, so has near infinite influence on the rate for overnight money.
The notion that the Fed follows markets rather than leads them is niether new nor all that hard to see past. A common analogy used to debunk the notion is the sale of cold-weather apparel. Sales of winter outter-wear pick up in most years before cold weather sets in. So either the purchase of coats brings on winter, or we humans are able to anticipate the future in some ways and to prepare for events that we anticipate. Market participants anticipate Fed rate adjustments, and market prices move before the Fed does.
Everybody is aware of the Fed essay from years ago entitled “Does the Fed Cause Christmas?”, yes? The point to the title is that the Fed anticipates increased demand for cash and so provides cash before it’s needed. This anticipation business is a two-way street.
One last thing, by the way. It’s pretty common for the market to price in changes in Fed policy in error. The market then adjusts to the Fed, rather than the other way around. Keep an eye on this stuff on a daily basis and you will see instances of this often enough.
Thanks for these graphs. In 1993, in a speech at Boston University Law School, I looked back 20 years and forward 20 years on a variety of financial subjects. I puckishly suggested that in 2013, on the 100th anniversry of its founding, the Fed would be put out of business because the politicians would relaize for the first time that the Fed was following, not leading, the inteerest rate markets.
Does the Fed Funds Rate not have very little influence on the real economy, unless the influence is psychological? 80% of U.S. loans are made by other than banks. What most investors are willing to pay for corprorate debt depends on what is being paid on Treas debt, as well corporate soundness and inflation expectations. The Fed, it seems to me, can inluence the rates on Treas debt through open market transactions, but even the Fed’s balance sheet is not big enough actually to set the rates in the face of a market that disagrees.
Chairman Greenspan’s famous “conundrum” was nothing more or less than the market going its own way on longer-dated Treasuries and agency debt. Mostly, the Chinese were willing to compete for the paper.
http://en.wikipedia.org/wiki/Federal_Reserve_System#Monetary_policy
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Unless the Fed is […] attempting to stage manage short rates via winks, nudges, and hints; then following up with a confirmation by adjusting the Fed Funds rate a week, month or quarter later.
If this fits your definition of the verb “set,” then we are not reading the same dictionary.
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Um, that’s exactly what they do! OK, I said “set”, which was somewhat wrong. Try “manages expectations and coerces the market until reality and target coincide”?
A couple of other points:
SS: “Karl, Just to be clear I’m talking about the pre-2008 period. Right now the Fed seems to have giving up targeting rates, and uses other tools such as QE2 (monetary base changes.)”.
http://www.themoneyillusion.com/?p=13706#comment-145367
SS: “So obviously there is a sense in which Karl is right. The Fed sort of “controls” (but doesn’t legally fix) the fed funds rate for 6 week periods. But the Smith quotation on top referred to T-bill yields, not the fed funds rate.”
Absolutely correct.
KS: “The interest rate on T-Bills is simply whatever the Fed wants it to be. T-Bills and excess bank reserves are essentially interchangeable. In normal times the value of excess reserves is the Fed Funds rate. Today it is the Interest on Reserves rate.”
Also absolutely correct.
Imagine you have a reserve excess. In normal times, you’ll lend it at the FF effective rate (which will be close to the FF target rate). If you can’t do that (say, no demand) you’ll withdraw it and buy T-bills, driving them down to an equivalent rate.
BUT we live in a world where, due to QE, the natural FF rate is negative:
“The expansion of excess reserves in turn has placed extraordinary downward pressure on the overnight federal funds rate. Paying interest on excess reserves will better enable the Desk to achieve the target for the federal funds rate”
http://www.newyorkfed.org/markets/ior_faq.html
So now the Fed controls T-bill rates by the rate of interest on reserves; you’ll prefer to hold reserves with interest rather than bills with interest.
And expectations drive the market, which is why time’s arrow goes backwards in the graphs.
Cameron –
That sounds pretty convincing. Though I do not share the belief you and Karl seem to have in the omnipotence of the Fed.
But this, from Catillonblog commenting (26 March, 2012 at 18:52) on Sumner’s post, is even more so. (Bolding added.)
Scott, I think you misunderstand the relationship between implied market pricing and Fed actions. When market participants starts pricing rate cuts more aggressively than the Fed itself expects to move (as revealed by the Fed’s rhetoric at the time, and its after the fact minutes), it is because the market sees further into the future and more clearly than the Fed. Nobody forces the Fed to do anything – it’s just that the market – as a dead white guy called Hayek pointed out – tends to incorporate many dispersed pieces of information, much of which could not be made known even in principle to a single mind, or group of minds such as the FOMC.
It is well-known to old hands that the stock market is much better at discounting future economic fundamentals then today’s fundamentals are at predicting the stock market in the future. Well the same is true of the bond market.
I suggest the following exercise for those who may be interested. Pick a currency zone, and pull up a weekly chart of the 5 year swap or high quality government bond yield for that market. Identify the major highs and lows. Then go back and read what central bankers were saying at the time – both in public, and in their minutes (when released with a lag). You will see that the market always turns ahead of the central bank, and the central bank always tends to resist believing changes that are starting to be discounted by the market. Central bankers are always trying to drive the car by looking through the back windscreen. Hence Bernanke’s concern about deflation in 2003 (as the world economy was about to recover), and the ECB’s concern about inflation in July 2008 (just as the wheels were about to fall off). So it’s just not right that the market bullies the Fed – the market is smarter than the Fed, and the Fed eventually has to recognize the market’s insight.
This, to me, makes perfect sense, comports with Occam’s razor, and requires neither temporal dislocation nor an excursion to the Chronosynclastic Infundibulum.
Cheers!
JzB
It’s not omniscience at the Fed, it’s the monopoly control it has in combination with the Treasury on issue of the dollar. The Treasury spends first, sells bonds latter and the Fed mops up imbalances down the pike as the reserve recording periods expire. See Fulwiller, Wray and Mosler.
To echo other commenters, just because there is a timing lag does not imply causation at all. The cause is expectations of the future, and if the market arrives at its response to those expectations faster than the fed, so be it. If the market is hedging future expections OF the fed response to expectations of the future of the economy, so be it.
Seeing a lag and concluding that the Fed simply follows the market is an unjustified leap.
Would not insider trading by people in the Fed explain this?
Would not insider trading by people in the Fed explain this?
Would not insider trading by people in the Fed explain this?
I see a lot of contrary arguments that are coherent, but no proof that I am wrong.
I see Fed followership consistantly over decades, with the biggest lags at turning points, which impericaly supports my contention.
I see zero contrary evidence, anywhere. So prove me wrong. I would accept that.
Is anybody willing to take on Catillonblog’s suggested exercise?
Cheers!
JzB
Err, it’s not incumbent upon us to provide a negative proof, it’s incumbent upon you to provide a positive proof.
I find his faith in Hayek … diisturbing. 😉
If markets are so prescient, how do you get the dot-com boom/bust, the mortgage boom/bust, the commodities … well you get the idea.
If the market drove the rate why does it go up in a straight line 04-06, plateau, then collapse? Why did it not go straight to zero at the turning-down point? (OK, why did it not go to 0.25, since the market would have known that the interest on reserves would be established at that rate, right?)
http://research.stlouisfed.org/fredgraph.png?g=6Vs
It looks more to me like announcements/expectations of “rates will go up until X”, “X happened, rates will stay here”, “OMG we’re doomed what can we do?”.
(Or “her”, I guess.)
Indeed. I can’t prove that traders use their expectations to trade.
But I can assert from experience (including 2008) that they do, and they really don’t enjoy life when they’re wrong.
C’mon – the Hayek reference is off-hand and irrelevant to the content. Please – no ad hominems.
I’m not claiming markets are prescient. Please do not agrue against claims I did not make. In fact, it seems ot me that expectatoins based mechanisms rely on prescinece, while in my claim, it is irrelevant.
I am claiming the market is a rate setter, based on whatever ebbs and flows of knowledge are available in the moment.
Also, the market (I assume) is policy netral – that is, there is no agenda other than maximizing profits. One cannot make that claim for the fed.
Cheers!
JzB
Of course traders use their expectatoins to trade. I’ve never argued against that. I’m arguing that a specific expection of exactly the FFR is not the main driver when the market sets a 3 Mo T-Bill rate. Nor can expectations be the only factor in the mix: liquidity preference, time preference, safety preference, and raw supply and demand must be operating.
Here is a Fed Working paper that shows statistically that –
1) FFR and 3 mo T-Bill rates are strongly correlated – no surprise.
2) Adjustment to equilibrium is born largely by the FFR, not T-Bill rates
3) Relationships among rates are considerable more complex than monetary policy and the expectations hypothesis suggest.
http://www1.american.edu/academic.depts/ksb/finance_realestate/mrobe/Library/ffr.pdf
In the conclusions section, the authors make some attempts to reconcile their results with the conventional view that other rates key off of the FFR, and offers some ifs that, if operating, would be consistnt with it. The just end up saying more work is necessary. The conventional view remains unproven.
Based on what I can find, there is zero evidence that 3 mo T-Bill rates actually react to the FFR. OTOH, a simple look at the data suggests otherwise.
My original contention still stands. If A precedes B, then any contention that B causes A has a serious burdon of proof. Time travels in one direction only, and assertions that B causes A are simply that.
Cheers!
JzB
“Err, it’s not incumbent upon us to provide a negative proof, it’s incumbent upon you to provide a positive proof.”
Well that is not how empiricism works in practice or theory. That is generally science proceeds by a series of models, each at least intending to explain a wider (if not necessarily 100% overlapping) range of data. And while the ethical standards of the field suggest that researchers not hide data points that clearly falsify the model, there mostly is not a completeness condition that makes every model need to conform to the traditional standards of ‘logical proof’. And mostly it is indeed the job of critics to provide enough counterevidence to amount to what could be called ‘negative proof’. Even as it is the job of the theory/model’s promoter to front what would be accepted as such proof.
JzB quite properly puts the whole matter/model in the form of a question and is begging for explicit and relevant answers.
If the history of thought over the last 200 years has taught us anything it is to be suspicious of totalizing ‘here be the end of knowledge’ models. Because too often the end product is fanatics clinging to Every Word of The Master and so obviating and obliviating inquiry altogether.
Effective Fed Funds vs Generic 1-month TBill looks awfully coincident to me, what exactly is your contention?
JzB,
It took me a little while to come around but I think you are really on to something valuable here. The Fed appears to follow the markets with regards to supplying reserves and altering rates (http://bubblesandbusts.blogspot.com/2012/08/markets-determine-interest-ratesuntil.html).