The Federal Reserve Does Not Control Interest Rates

This article is written for those not familiar with the economics of money and banking.  For those who understand that subject see: https://www.econlib.org/library/Columns/y2013/Hummelinterestrates.html

The Misunderstanding Created by The Popular Media

In the popular media, including television shows dedicated to business news, one freqeuntly hears this: “It is expected that the Federal Reserve will lower (or raise) interest rates at its next Fed Board meeting”. Or even, “The Fed just lowered interest rates and this will bring down consumer loan rates like credit cards and mortgage loans”.

This is seriously misleading. The Fed only changes the Fed Funds rate. This affects other market interest rates, but not necessarily all in the same direction, and in a different way in the short term vs. the long term.

Some of the people that say “the Fed changes interest rates” are aware that the Fed changes only its Fed Funds rate, but they think that their audience understands that it is the Fed Funds rate. Yet, people have at times told me that the Fed sets mortgage interest rates. This misunderstanding is obviously the result of the way this topic is discussed in the media.

What Are Fed Funds and How They Affect the Money Supply

Fed Funds are interest-paying loans repayable on the next day. They are like government or corporate bonds, but with a very short maturity. And they are bought and sold among banks and between them and the Fed.

When the Fed buys Fed Funds it pays for them with newly created bank reserve money (in the form of a deposit to the banks’ reserve account at the Fed). This Increase in the banks’ reserves allowes them to make a larger volume of loans to the public. These bank loans are also made by increasing the balance of the borrowers’ checking accounts.

The increase in bank lending becomes circulating money, also known as the “money supply”, which only includes money held by the “non-bank public” in the form of paper currency, coins, and checking accounts, also known as M1. Adding money market accounts that allow six transaction per month makes it into M2 .

This increase in Fed purchases of Fed funds increase their demand, therefore their market value, which reduces: (a) the ratio of its fixed interest rate to their market value, known as their yield, and (b) the interest rate of newly issued Fed Funds.

In summary, a Federal Reserve’s reduction of the Fed Funds rate requires increasing the money supply. And, of course, increasing the Fed Funds rates requires reducing the money supply.

How the Fed Funds Rate Affects Other Market Interest Rates

Inflationary Expectations

An increase in the rate of growth of the money supply produces more inflation that would otherwise would have happened. Therefore, lowering the fed funds rate increases the inflaition rate.

One of the most important factors affecting all private market interest rates is the expectations about future inflation. Price inflation reduces the value of the money that will be retuned to the lender in the future. Therefore, expectations of rising inflation lead the buyers of interest-paying bonds to sell them, reducing their price. And a decline the bonds price in relation to its fixed interest rate increases its yield.

In the nineteen thirties a University of Chicago economist named Irvin Fisher dicovered that interest rates at a given time correlate with past inflation rates, and this has been confirmed by other economists. Apparently, since future inflation is very difficult to predict, expectations about future inflation are mostly based extrapolating past inflation trends into the future. This is called the Fisher effect.

The Immedate Effects Vary by the Term of the Loan

However, there are a few situations that do allow bond investors to predict future inflation from the present. And one of them is a reduction in the Fed Funds rates because it requires an increase in the money supply, an act that increases future inflation.

The impact of an increase in the money supply on inflation is very gradual, its full effect can take 12 to 16 months. Therefore holders of short-term bonds (less than 6 month) will feel very little, if any, of this inflation, so their bonds and other short term lending insturments are not affected by it. Therefore the increase in the Fed purchases of Fed Fund will reduce the yields of short term bonds because they are near competitors with the Fed funds rate, but only temporarily (explained below).

But the holders of long term bonds and mortgage loans will have the value of what they get paid back in money significantly reduced by the future inflation, their prices will fall and their yields will rise. The larger the reduction in the Fed Funds rate the greater is the increase in the money suply, and on the yields on the long term bonds.

The Immediate, vs the Long Term Effect

While short term market interest rates do move in the same direction as the Fed Funds rate in the short term, eventually, the Fisher effect catches up with them. In other words, as time passes, eventually short-term lenders will estimate the inflation of the next six months by extrapolating it from the previous six months.

Therefore, as the inflation rate of the previous six months rises, their interest rates will eventually rise above the level of what they were before the original reduction in the Fed funds rate. This is because now, past inflation is higher. Therefor inflationary expections, therefore interest rates, are also higher based on the Fisher effect.

And the same will happen with the long term bonds. The actual inflation of the past reinforces the inflationary expectations that were originally created by the increase in the money supply from Fed funds purchases meant to lower the Fed funds rate.

Other Factors Affect Interest Rates

These are a sample of some of the most important other factors that can affect interest rates:

(a) A great innovation increasing the demand for borrowing funds to invest,

(b) an increase in borrowing by the federal and state governments,

In addition the Fed usually gives hints about the direction of the next month’s change in the Fed Funds rate. This starts affecting financial markets before the change in that rate takes place. So some effects of changes in the Fed funds rate start happening before it actually changes. Therefore, one has to take that into account when observing how changes in Fed funds rates affect other interest rates.

These other factors affecting interest rates sometimes obscure some of the interest rate relationships between inflation and inflationary expectations described above. But, it is clear that: (a) the Fed funds rate does not move all market interest rates in the same direction that it moved, and (b) that the initial direction of the effect of the Fed funds rate on market interest rates reverses itself over time.