The Fed, Part 4: The Federal Reserve Does Not Control Interest Rates
Fed control is a mass delusion that sits in plain sight
We are here to discuss the granddaddy of Federal Reserve claims: we control interest rates.
No, you do not.
"The price of information, we change it at whim with buttons” assures the FOMC. They gather around and observe some lagging indicators and then tell you they've decided what money will cost for a $27-trillion-dollar economy.
They then hold a series of interviews and press conferences trumpeting their claims. You obey and accept Fed power without a second thought. They tell you to jump, and you leap as high as you possibly can. Why? If I described the USSR doing this with different names for things, you’d think it’s a communist fantasy; you’re not wrong.
An obvious, yet important point: An institution that reacts off of lagging information... definitionally does not lead anything.
You’d laugh at anyone that told you he drives via the rearview mirror and dictates traffic by yelling at it, don’t make exceptions to this. You have never critically questioned Fed power, because absolutely no one does. Not should they do it, but can they do it. You’re told the omnipotent magical institution did some magic, and then look to advocates of the omnipotent magical institution to confirm the claims.
You have the same beliefs about the Fed as BlackRock, The Economist, every Fed employee, Davos, CNBC, etc.. You get ALL of your information about the church from its clergymen. And you find this credible? Why do you accept this when you’d reject it anywhere else? Every single money manager, normie, pundit, retail trader, hedge fund analyst, and everything in between accepts it uncritically. You’re told “don’t fight the Fed” just like a Catholic tells you “don’t question God”.
Let's review the church's divine monetary grace together.
What Actually Happens When the Fed “Changes Interest Rates”
What exactly goes down when the Fed tells you it’s raising or lowering interest rates? How is it implemented and enforced? Let’s get really specific.
The Fed provides a target range for the Federal Funds Rate (FFR) when it announces rate changes; the FFR is a rate for overnight reserve lending between banks. The Fed doesn’t actually set the FFR; it’s an overnight lending rate set by supply/demand in the interbank lending market. The Fed provides a desired range for the FFR, and then encourages it with economic incentives. It holds a series of extremely flamboyant press conferences when it does this.
Please sear this into your mind: when the Fed “changes interest rates” it is quite literally issuing a range it would like an overnight bank lending rate to be.
How Is the FFR Enforced?
The FOMC holds a press conference and announces… an interest rate change. Everyone is tripping over themselves, CNBC’s next 372 guests will be discussing it. Call your mother and tell your friends: overnight interbank lending rates have been altered.
As mentioned, the Fed doesn’t actually set the FFR, it’s a market rate. So how is the Fed's target range enforced? Economic incentives. All of them straightforward. Here’s how they do it:
The IORB (interest on reserve balances): The IORB is set by the Fed and it's what banks earn on their reserves at the Fed. Think of it like the bank’s savings account and the interest rate they get. The IORB plays a big role in how the Fed gets the FFR it wants.
Open Market Operations: The Fed toys with supply of repo collateral by buying and selling USTs. Small tangent: This is all QE/QT does. It changes the composition of bank balance sheets and makes everyone think a liquidity happened because reserves were shuffled around. Imagine if your bank moved money in your savings account to checking, does the world have more money now? When “QT” happens it moves it from checking to savings. Liquidity! All still held at the Fed. None of this gets lent out. Pavlovian games (this is thoroughly detailed in The Fed Part 1).
The Discount Window (DW): The DW is the rate banks pay to borrow directly from the Fed; it’s a lending rate the Fed directly sets. There’s stigma in the banking world associated with using the DW, because it implies trouble if you need to access it, so it’s not used as often as other tools. There's such stigma that the reporting of who used the DW operates on a 2-year delay to avoid shaming (really). The DW is set higher than the FFR to discourage its use unless necessary. You can think of it like a ceiling of sorts for the FFR.
Reserve Requirements: The Fed can dictate the reserves banks must hold against their loans/deposits. While this does impact FFR behavior, it’s not a tool they modify very often. The reserve requirement has been zero since 2020, meaning capital adequacy ratios are actually what’s constraining lending, but that’s a different conversation.
Overnight Reverse Repurchase Agreements, aka “reverse repo” (RRP): RRPs remove reserves from the system. The bank lends the Fed money, and gets securities to collateralize the loan, plus interest. If the FFR dips too low, you can use the RRP to get a better rate on your cash.
The Standing Repo Facility (SRF): created June 2021, it's the inverse of the RPP. Instead of the bank lending cash to the Fed, it lends Treasurys, receives cash, and pays the Fed interest. If the FFR goes out of range, you can access a repo loan from the Fed at a better rate.
Important: I don’t doubt the Fed’s ability to control the FFR. It clearly can. The economic incentives keep it in check. What we are going to explore is why, exactly, have they so thoroughly convinced you that this little overnight rate is so magical that it controls economic activity for the rest of the world.
Why Does An Overnight Lending Rate Get Everyone So Excited?
Interesting, isn't it? Here’s how the Fed thinks the FFR interest-rate process works its magic. The below is literally from the Fed. Observe the sheer power of "policy transmission"(!)
Neoliberal economists (Keynesians) have well-known disdain for “trickle down economics”. But the rationale for how the FFR changes the cost of money for the deepest, most-sophisticated markets in the world follows the same reasoning. Introducing “trickle down interest rates”.
The official-yet-unofficial explanation for how the Fed controls the collective price of money: If the FFR changes, then the entirety of the most liquid, intelligent market in the world (Treasurys)… just listens.
How does it listen? Well, there’s a lovely academic theory why. It doesn’t manifest in reality, but it will get you an A+ on an economics test. This is the entirety of the rationale, right here, in one academic wishful-thinking snippet. Why does one little lending rate that the government influences magically change the cost of information for a $27T economy? Pure theory. Don’t take it from me, here’s Alan Greenspan’s answer:
Related: remember this South Park episode? Step 1, step 2…. profit. Take this logic and dress it up with some academics and economic pseudoscience and there isn’t much difference here. “Policy transmission”.
Why Did You Get So Technical and Specific?
Did you know it was just an interbank lending rate? Did you know why they think this transient little rate is apparently a hybrid of God’s Will and Thor’s Hammer rolled into one? See, you have to be technical here because meaningless platitudes reign supreme in any dialogue surrounding the Fed; we are not doing that here. We must be specific, and build upon each specific point.
You don't prove a negative (a claim you can't do something), you prove a positive (a claim you can do something). Yet here I am, proving a negative. You understand the government lies and manipulates about its abilities almost constantly, but not here though. No, when it comes to monetary policy the Wizard of Oz is honest about its control.
Don’t let “dude, trust me” work when a government institution wants you to believe it’s omnipotent. Ask questions, get specific! A religious, mythic mystique seduces you into abandoning an evidentiary standard. You have strong opinions about what the Fed should do, but you have zero questions about whether it can do those things in the first place. Do not simp for a government institution. Demand proof when it has a very obvious motivation for deception. Do not trust, verify.
I’m not asking you to agree with me, I’m imploring you to examine extraordinary claims critically. My claims are NOT extraordinary, THEIRS are. You have been psyoped into believing otherwise.
You need to see how the sausage is made to understand you’re not eating steak. One overnight bank rate is not — and I can’t emphasize this enough — the dictator of the collective cost of money. There is not one rate to rule them all. There are in fact many interest rates, and we will review the most-critical ones shortly.
That which can be asserted without evidence, can be dismissed without evidence. I’m about to show you evidence, they are providing you academic theory and monolithic chanting. Breaking down the details demystifies the “dude, trust me” of Fed power. Once the aura has been shaken, you can start assessing it like you would anything else.
“If the Fed only changes the FFR, why does everyone obsesses over it? This rate must result in something else happening...?”
Yes. When Fed acolytes hyperventilate it’s not really because of the FFR, even though that’s all the FOMC does. The focus is (hopefully) on something else. What everyone cares about is real life, boots-on-the-ground rates that people experience. The FFR is not what’s used for real-life financial activity. It’s not how hurdle rates for business and investment are determined.
The US Treasury Market vs The Fed: Who Dictates to Who?
You’ve been provided no hard evidence the Fed controls the cost of money, but since my claims are iconoclastic I do require evidence. So let’s examine what goes into interest rates that directly impact economic activity.
The interest rate of greatest consequence is the US Treasury (UST 10-year bond (10yr). It’s a common reference for discount rates and the risk-free rate for business activity. However all USTs matter for interest rates we experience in real life.
When the UST 5yr, 7yr, 10yr, 30yr, etc. move, other interest rates of similar duration move too. A 30-year mortgage and other real-life rates you encounter are influenced by UST bonds of roughly the same length.
USTs are considered ‘risk free’, and from a default standpoint that’s true. Say a 30yr UST has a 4% yield, then your mortgage (which is riskier) should have a higher rate. This is called risk premium, or credit spread. This logic applies to corporate debt and bonds pretty much everywhere. This is why the UST curve matters. This is why the price of government debt can affect your car loan.
It’s these longer-dated bonds (5-30yr USTs) where the economic action is, because it affects the cost of credit for everyone else. UST rates act as a guide for the rates people and businesses experience.
Here are charts, evidence, I’ve put together to illustrate what actually informs interest rates, and how the Fed tags along claiming credit for what's already happening. Remember: something that operates reactively off lagging information definitionally does not lead anything.
What informs interest rates? It’s inflation + GDP growth. That’s it. That’s the answer.
Whatever the sum of those two things are informs nearly all of what rates are. Let’s see what this looks like historically.
What I’ve done is take the annual inflation rate and GDP growth going back to 1956 and added the two together. We’ll call the rate produced by GDP + inflation the Core Yield (CY). Then I’ve taken the US 10yr and plotted it with the CY.
Observations: Looking at 1956 - 1980, a period of rising inflation, the CY consistently leads the 10yr higher. In periods of declining rates, the CY and 10yr were very closely aligned, almost in lockstep.
Please note: look at how the CY shot up at the end of the chart. I wonder what happened next?! Must have been a Fed decision!
Now let’s smooth this out with 5-year averages of both and see if it looks any different.
The observations on the 5-year average of the CY and the 10yr going back to 1956 are the same as before. The CY leads in rising environments, and then tracks closely in declines. Inflation and GDP growth are what inform interest rates. You do not need a PhD thesis or peer-reviewed study to understand this.
And now for a fun chart: let’s add the FFR to the mix. Surely we should see the FFR leading since the Fed is directing things…?
This chart may seem overwhelming, but it’s just annotations. The data is simple. Again, please remember: something that lags does not lead.
Concluding
That’s it. This doesn’t need some multivariate regression P value obfuscation to explain further. You can believe your lying eyes. The truth of how rates are derived is macroeconomic inputs that nobody controls.
Does the Fed control GDP growth and inflation with buttons? Obviously not. Not even the most fanatical of Fed worshiper would make such a claim; but that’s what you’d have to be asserting to believe the Fed controls interest rates.
You’d have to claim that the Federal Reserve controls the inflation and growth figures for a $27 trillion economy with an overnight lending rate. Patent absurdity. But this is what you de facto think when you claim this institution controls interest rates.
Observation: isn't it odd how no one can predict rates, not even the Fed! How can this be if they control them? Smart guys like @balajis have the answer right in front of them. Even remarking how it’s weird the Fed can’t predict the thing they control! Yeah, about that...
I inculcate these points because this is how political misinformation is undone. The age of the internet allows for greater meritocracy and distribution of info. But credentialism still matters. Jeff Snider and I are the only two guys I know of saying this. What can I reasonably expect to accomplish?
The best I can hope for is you walking away thinking: “Well he did make sense, interest rates do seem to be macro inputs the Fed doesn’t control. But…. it’s too fringe. I can believe this quietly to myself but can’t admit it publicly.” Fine. I accept this. Until CNBC and everyone internalizes this reality, you can’t speak out against the crowd. So try and do this for me: stop saying “the Fed changed rates”. Begin by just slightly modifying your language, try “interbank lending rates changed”.
Try it. It’s true, you’re not saying anything wrong, and the subtle tweak of language removes the undeserved reverence you give to this institution every time you credit it for something it cannot do.
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