The Federal Funds Rate (FFR), set by the Federal Reserve – the interest rate that everyone obsesses over – is a strange creature. It is not what it may seem, or what many people assume it to be.
- To begin with, it is not an actual interest rate attached to any real loan – the FFR is a target which no one is required to go along with.
- The target applies only to inter-bank lending – that is, to banks in the Federal Reserve system which loan reserves to each another
- The target applies only to the shortest of short-term loans – it is a target for overnight lending rates
The FFR is really more like a polite suggestion to banks which may or may not decide to go along. The suggestion applies only to a very narrow category of loans that may or may not happen, and which, if they do happen, involve transfers of funds that remain entirely within the closed system of reserve accounts deep inside the Fed itself. The motivation for these transactions is generally regulatory rather than economic. They are designed to ensure compliance with the Fed’s reserve requirements. The FFR does not apply to any real loans to businesses or consumers.
Nevertheless, this peculiar inside game involving the manipulation of an ultra-short-term target does seem to drive changes in the broad interest rate regime that regulates the flow of credit in the real economy. The FFR typically appears to push economically important long-term interest rates to sync up, directionally. Over the last 5 years, the yields on 10 year Treasury bonds moved in lockstep with Federal Reserve interest rate targets. The correlation was 92%. The same was true for rates on 30 year fixed-rate mortgages, which showed a correlation of 94% with the FFR.
This might suggest that the Federal Reserve does indeed wield a powerful and precise instrument for influencing important long term rates – the foundational myth upon which the Fed’s credibility rests. In the previous column, the hollowness of this myth was detailed. The Fed’s ability to influence the real economy has been grossly oversold. Instead, we have a kind of confidence game where the Fed’s power is a matter of faith – as long as we believe in it, the illusion will retain its power.
Until recently that belief has been strong. It has caused the syncing process to extend to the stock market itself. The market has shown extreme sensitivity to Fed announcements, possible announcements, redacted minutes, the phraseology of the leadership in various press encounters – resulting in a pronounced clustering of stock returns around the days when the Federal Open Market Committee meets.
This is extraordinary. There are only eight regularly scheduled FOMC meetings a year. If those eight days are removed, the gains of the S&P 500 on the other 347 days of the year are severely diminished.
[Note that this effect only appeared in the Greenspan years, where – arguably — an important shift in Fed communications policies emerged, aimed more explicitly at influencing the financial markets. Of course, this was never part of the Fed’s mandate, and there are many who view this innovative new mission with skepticism.]
Is this healthy? Is it sustainable? And what happens if Faith at some point falters? These are weighty questions. And at the moment, a smidgen of doubt may be emerging, following the recent long-awaited cut in the FFR target.
The Sept 16 Rate Cut
On September 16, Jerome Powell announced a 50 basis point reduction in the Fed Funds target rate, as described in a previous column. It was the first cut in more than four years. It was seen as an “emphatic” trend reversal, and the signal of a shift to monetary easing that will see interest rates begin to drop across the board, presumably providing a stimulant to a softening economy.
But this time the markets didn’t follow the Fed’s “suggestion.” Real interest rates in the real economy rose, rapidly and substantially. The yields on the 10-year Treasury bond climbed 40 basis points, closing above the significant 4% mark today (October 7).
Interest rates on 30-year Fixed mortgages were up 58 basis points (as of October 4).
Consider the disconnect.
The Federal Reserve dropped its target rate by 50 bps, and yet market-based benchmark rates increased by more or less the same amount. The “spread” between the policy rate and the market rate over this three-week period widened by a full percentage point. Spread across the $25 trillion U.S. economy, and the $46 trillion bond market, that is a huge discrepancy.
There is a lesson here. The Fed’s power to move the credit market is not automatic, as many people assume. Yes, it is likely that in time the market rates will begun to track downward. But the truth may have blinked through the illusion here. Is this causation, or just correlation? The Federal Reserve and the financial markets may both reach a similar conclusion, but that does not validate the efficacy of the Fed’s policy moves. Certainly for the moment what is in display is the independence of the markets in declining to immediately accept the new easing regime.
This is not actually that unusual. Over the last year the correlation of the Treasury bond yields with the FFR was just 34% (a far cry from the 5-year averages). Since the FFR was fixed at 5.25% over that period, this means that the Treasury yields were bouncing around quite a bit, reflecting the market’s changing views on the probability and importance of various future events (recessions, soft landings, Fed policy changes) – rather than chaining themselves to the Fed target.
And in the year before that (Oct 2022-Oct 2023), as the Fed was cranking up the target rate, correlations between the FFR and both the 10-year Treasury yield and the 30-year mortgage rates were lower still, around 20% – which means that the relationship was quite weak indeed.
A full percentage point of “adverse” reaction from the financial markets against the Fed’s suggestion is, well, at least a little bit shocking. This is one more chink in the Fed’s armor, even if the rates do eventually converge. It is starting to seem like the Fed’s chief asset — its credibility – may be at greater risk than it has been. Even the sober citizens who edit the Washington Post are worried. “The Federal Reserve’s greatest resource is its credibility. People have to believe…” If belief falters, “the central bank won’t survive.” True, the Post’s concern here was focused on questions about personal transactions by Fed officials, but the modes of impairment that can threaten the public’s faith in the institution are multifarious. Public confidence in the Federal Reserve today is at or near an all-time low, and these small signals of the market’s disdain for the Fed’s intentions should not be discounted.
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