This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics.
Based on the fact that the Fed’s contribution to the supply of credit is minuscule relative to the size of the credit market (which is increasingly international) and my extensive empirical research, I have been skeptical of the Fed’s ability to significantly affect interest rates.
However, in research I published in 2018 (Greenspan’s Conundrum), I found the Federal Open Market Committee (FOMC) began using the overnight federal funds rate as its policy instrument in the late 1980s.
Since then, the FOMC has been able to control the overnight federal funds rate, initially by signaling its target in various ways, and since June 1999 by announcing the target (It does not control the federal funds rates with open market operations as economic textbooks and some economists assert. It never has. Indeed, I’ve shown this is impossible here).
More importantly, my research showed since the late 1980s, changes in the funds rate target have affected Treasury rates along the yield curve; the effect gets larger as the maturity of the security gets shorter.
In a recent talk to the Wisconsin Bankers Association here, Jim Bullard, President of the Federal Reserve Bank of St. Louis, noted the Fed’s influence over the 2-year Treasury rate is much stronger than its influence on the 10-year Treasury rate. He then presented a figure with the 10-year and 2-year Treasury rates daily from October 2018 to January 7, 2020.
Noting the 2-year Treasury rate declined 144-basis points from November 8, 2018, to January 7, 2020, he attributed the entire decline to the FOMC’s monetary policy. Based on my research, I’m skeptical of this claim. This essay explains why.
The figure below, which is similar to the one President Bullard used, shows the 10-year and 2-year Treasury rates and the mid-point of the FOMC’s federal funds rate target range from July 3, 2017 to January 20, 2020.
The vertical line denotes November 8, 2018, the date when the 2-year Treasury began its descent. One reason it is difficult to believe monetary policy caused the 144-basis-point decline in the 2-year Treasury rate is the fact that 2-year Treasury rate had already declined 35 basis points by December 19, 2018, when the FOMC increased the funds rate target 25 basis points.
Moreover, on January 4, 2019, Chairman Powell said the Fed would be more patient about raising rates in 2019. It’s hard to believe market participants would take this as a signal the FOMC would start reducing the federal funds rate soon. In any event, the FOMC didn’t make the first rate cut until July 31, 2019. By then the 2-year Treasury rate had declined 109 of the 144 basis points.
The behavior of the 2-year rate relative to the 10-year rate during the period of decline also makes me wary of President Bullard’s claim. Maturity is a strong factor linking interest rates. Two securities with the identical maturity tend to move together even if they differ in default risk, with the spread between the rates being determined by the market’s perception of the relative risk of default.
Two securities with identical default risk, such as Treasuries, move together even though they have different maturities. The spread between Treasuries with different maturities is strongly influenced by the market’s perception of whether the structure of interest rates will be rising or falling: Spreads tend to narrow when interest rates are rising or expected to rise and widen when interest rates are falling or expected to fall.
As I noted above, since the late 1980s change in the FOMC’s federal funds rate target have affected Treasury rates, with the effect being stronger the shorter the term to maturity. As a consequence, the spread between the 10-year and 2-year Treasury rates has typically widened more since the late 1980s whenever the FOMC reduced the federal funds rate target.
This didn’t happen this time. Both rates have fallen pretty much in lockstep since November 8, 2018. This suggests the possibility that both rates declined because market participants reacted to news of various kinds that moved rates lower.
The figure shows this experience is not unique. On September 8, 2017, the 10-year and 2-year Treasury rates began to increase three months before the first of five 25-basis point increases in the federal funds rate target on December 13, 2017.
The spread between the rates, which had been narrowing, initially widened somewhat when the rates began to increase; just the opposite of what you’d expect if the change was prompted by expectations the FOMC was about to increase the target again.
Policy actions are supposed to be driven by economic and inflation concerns. Policymakers will never admit they might be influenced by other considerations.
However, I believe it is possible the significant increase in these rates might have encouraged the FOMC to increase its federal funds rate target sooner than it expected, i.e., the FOMC followed rather than led the market.
This possibility is supported by the fact that the FOMC’s economic outlook in the November 1, 2018 and December 12, 2018, statements (reproduced below) are nearly identical (identical sentences are in bold print). Furthermore, the November 1, 2018, statement read: “In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent.”
The December 13, 2018, statement was identical except for the action: “In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1-1/4 to 1-1/2 percent.”
If there were no significant changes in economic conditions, inflation, or inflation expectations, why did the FOMC decide to raise the rate in December, but not in November?
It’s likely the same thing happened in mid-2019. The policy outlook for the June 19, 2019, and the July 31, 2019 meetings are nearly identical. But I’ll have to wait until the verbatim transcripts of these meetings are released to know whether I’m right.
FOMC OUTLOOK STATEMENTS:
Statement on November 1, 2017: Information received since the Federal Open Market Committee met in September indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate despite hurricane-related disruptions. Although the hurricanes caused a drop in payroll employment in September, the unemployment rate declined further. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. Gasoline prices rose in the aftermath of the hurricanes, boosting overall inflation in September; however, inflation for items other than food and energy remained soft. On a 12-month basis, both inflation measures have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.
Statement on December 13, 2017: Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Averaging through hurricane-related fluctuations, job gains have been solid, and the unemployment rate declined further. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. On a 12-month basis, both overall inflation and inflation for items other than food and energy have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.
Statement on June 19, 2019: Information received since the Federal Open Market Committee met in May indicates that the labor market remains strong and that economic activity is rising at a moderate rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained low. Although growth of household spending appears to have picked up from earlier in the year, indicators of business fixed investment have been soft. On a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2 percent. Market-based measures of inflation compensation have declined; survey-based measures of longer-term inflation expectations are little changed.
Statement on July 31, 2019: Information received since the Federal Open Market Committee met in June indicates that the labor market remains strong and that economic activity has been rising at a moderate rate. Job gains have been solid, on average, in recent months, and the unemployment rate has remained low. Although growth of household spending has picked up from earlier in the year, growth of business fixed investment has been soft. On a 12-month basis, overall inflation and inflation for items other than food and energy are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed.
EDITOR'S NOTE
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.
