Does The Fed Set Interest Rates?

The Subtle Ruse of Federal Reserve Policy

Prevailing wisdom in the financial markets is that the Federal Reserve directs interest rates by decree, and to “fight the Fed” is to set yourself up for financial ruin. The more savvy investors might understand that the Fed doesn’t actually set interest rates, but rather influences interest rates through its monetary policy tools, particularly the Federal Funds Rate (FFR). The FFR is the interest rate at which banks lend reserves to each other overnight. It is assumed by that by controlling this rate directly, it therefore bends the rest of the yield curve the way the Fed wants. But this is also false.

The Federal Reserve does not set a target for the FFR based on its assessment of economic conditions and its dual mandate of promoting maximum employment and stable prices as is assumed. Instead, the Fed “policy-makers” observe the bond market’s assessment of economic conditions and align the FFR with what bond traders have already been doing for several months.

You can see in this graph from the St. Louis Fed’s FRED tool that in fact the FFR lags the inflection points on the 2-year Treasury yield by on average 4-6 months. Contrary to the mainstream narrative on Fed policy, the Fed does NOT conduct open market operations, buying and selling government securities in the open market, in order to influence bond yields. Instead, the Fed ensures that it’s not “fighting the tape”. Declared Fed policy must not be kept too far from free market yields as determined by traders.

The Federal Reserve is not leading the parade, but rather following. Just because Jerome Powell stands out in front of it doesn’t mean he’s directing where it’s going. He’s constantly looking behind to ensure he’s still walking where the parade is intending to go. His “open mouth operations” might have some influence over traders’ decisions in the short term, but ultimately they are mostly dependent upon inflation, economic growth, global economic conditions, market psychology, and expectations about future economic conditions.

The 2-year Treasury yield peaked in October, 2023. This suggests that the FFR will be officially cut in the March to June time frame if following the average precedent. The cut will come sooner in the event of a financial panic which sends the free-market bond rates plummeting as traders pile into the safety of bonds. It could be slightly delayed if bond yields consolidate in the same general area rather than trend lower, such as occurred in 2007. There are a lot of black swans — government shutdown, BTFP expiry, bank failures, ratings downgrades, earnings disappointments, recessions declared around the world, global war flare-ups in Ukraine, Gaza, and Taiwan, another global pandemic (Disease X), power grid failures, immigration crisis developments, cyberattacks, etc. The likelihood of yields and therefore the FFR falling sooner than later is therefore better than average, and when that happens, usually the yield curve reverts and a recession is declared.