This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.
The Federal Reserve is viewed as being very powerful. It is believed to strongly influence, if not control, interest rates, exchange rates and inflation. But exactly how it is able to do this is mysterious.
The truth is the Fed’s ability to influence interest rates is due to the fact that market participants believe it can.
As was the case for the all-powerful Wizard of Oz, pulling away the curtain will significantly reduce the Fed’s power. Let’s pull away the curtain on the Fed’s ability to influence interest rates.
The interest rate is the price of credit. Consequently, the Fed’s ability to affect interest rates stems solely from its ability to change the amount of credit it supplies to the financial market. The Fed does this by making loans to banks and by purchasing securities. Historically, the Fed purchased short-term Treasuries.
After the global financial services firm, Lehman Bros., declared bankruptcy on September 15, 2008, the Fed began purchasing long-term Treasuries, mortgage-backed securities and government agency debt. In response to the coronavirus, the Fed added corporate and state and local government debt.
Of course, the Board of Governors of the Federal Reserve can do other things. It can set the interest rate it charges banks when they borrow from the Fed, the interest rate the Fed pays banks for holding excess reserves, and banks’ reserve requirements.
Setting the interest rate it charges banks to borrow has never been effective because banks have never borrowed much from the Fed, and even less since the mid-1980s when large banks stopped borrowing from the Fed. The interest rate the Fed pays banks to hold excess reserves is not a policy instrument. The Fed merely adjusts it when it changes the federal funds rate target, and changing banks’ reserve requirement hasn’t been used as a policy instrument for at least 70 years.
Hence, the only thing the Fed can really do to influence interest rates is to change the amount of credit it supplies.
The Fed’s power to affect interest rates by changing the amount of credit it supplies is severely limited by several well-known facts. One is the fact that the financial market is extremely large. The U.S. bond market alone is estimated to be about $40 trillion. But financial markets are international. Consequently, the relevant bond market is several times larger.
There is also a high degree of substitutability among securities of different maturities and types, e.g., Treasuries, corporate debt, mortgage-backed securities etc. Financial market participants seek the asset that pays the highest return consistent with their tolerance for risk.
When the interest rate spread between two securities that are perceived to have the same or similar risk widens, investors will sell the lower yielding security and purchase the higher yielding security; this is called arbitrage.
Moreover, some investors are willing to trade off risk for higher returns. When the return differential between securities with lower risk and those with higher risk gets too wide, some investors will trade some additional risk for the higher return—the wider the return differential, the larger the number of investors who are willing to do this.
Consequently, there is even substitutability between stocks and bonds. This is why the stock market performs better than economic fundamentals would seem to warrant when interest rates are historically low.
Finally, there is overwhelming evidence that financial markets are efficient. A market is efficient when new information is quickly and completely reflected in market prices.
Since new information is impossible to predict, so too are interest rates, exchange rates and a variety of other prices.
For all of these reasons, the relevant financial market is immense. The Fed would have to increase the amount of credit it supplies by a lot to significantly impact interest rates. How much is hard to say, but the evidence indicates it’s more than the Fed has done so far.
Prior to Lehman’s bankruptcy, the Fed never increased the amount of credit it supplied the market by more than $55 billion annually. The Fed only increased the amount of credit it supplied by $741.5 billion during the entire period from January 1975 to August 2008. But $709 billion of this was to accommodate the public’s demand for currency. Only a tiny amount was used to implement its interest rate policy.
At this point you might note that the Fed was able to control the federal funds rate well since the Fed under Alan Greenspan began using the federal funds rate as its policy instrument in the late 1980s. So how exactly did the Fed do this? The Fed was able to control the federal funds rate with what economists call “open mouth operations.” The Fed signaled where it wanted the funds rate to be and the market took it there.
As the Fed became increasingly open about its target, the federal funds rate tracked the target more closely. On June 30, 1999, the Fed began announcing the specific target. Since then the funds rate has tracked the target very closely: The average daily difference between the federal funds rate and the Fed’s target is zero from that date until September 14, 2008. The market put the federal funds rate where the Fed wanted it to be because market participants believed the Fed could and would do it anyway.
Aware that the Fed’s federal funds rate policy had at best a modest effect on long-term interest rates that mattered most for spending, and with the funds rate at it zero lower bound the Bernanke Fed decided it needed to be more aggressive.
Consequently, it enacted a large-scale-asset-purchase program commonly referred to as quantitative easing (QE). In March 2009, the Bernanke Fed announced that the Fed would purchase up to $1.75 trillion in long-dated Treasuries, mortgage-backed securities and agency debt. Interestingly, the Bernanke Fed argued that because financial markets are efficient all of the effect of these purchases on interest rates would occur when the purchase was announced.
If it didn’t, it would be possible for someone to purchase the bonds on the announcement and sell them later when interest rates went down and bond prices went up.
The 10-year Treasury rate declined 51 basis points immediately following the March announcement; most other rates declined by about half this amount. The decline in the 10-year Treasury rate prompted Janet Yellen, then a Fed Governor, to say there “was compelling evidence that purchases of longer-term Treasury securities worked to bring down borrowing rates” at the Fed’s April 2009 meeting.
The decline in the 10-year Treasury rate was short lived. By the June 2009 meeting the 10-year Treasury was 121 basis points higher than it was before the March 18 announcement. This prompted Yellen to revise her assessment of QE’s effectiveness at the June meeting saying, “Initially I was an enthusiast for long-term Treasury purchases…but it has been awfully hard to identify exactly what that effect is.” This didn’t stop the Fed from purchasing even more long-term Treasuries and other securities in an attempt to stimulate spending by pushing long-term interest rates lower.
There is no compelling evidence this was effective. For one thing, interest rates stopped responding to purchase announcements (see Effectiveness of QE). Long-term rates, which Alan Greenspan and most economists acknowledge are determined by economic fundamentals and not by the Fed, trended downward cyclically from November 2009 to September 2019.
The downward trend was likely due to anemic post-recession economic growth, which averaged just 2.4% over this period. Longer-term rates in Europe and elsewhere also declined and to very low levels. Hence, the decline in longer-term rates was being driven by market forces, not the Bernanke Fed’s QE policy.
The coronavirus spurred the Fed to increase the amount of credit it supplies the market in an attempt to reduce long-term rates.
It did this in spite of the fact every economist knows that lower interest rates won’t incentivize spending in an environment of declining income and tremendous uncertainty. In any event, there is again no evidence these actions reduced longer-term interest rates. The Fed reduced its target for the federal funds rate to zero on March 15, 2020.
However, by then both the 10- and 2-year Treasury rates had already declined by over 1 percentage point. Both remained relatively constant despite the fact that the Fed increased the supply of credit by over $2.0 trillion.
Given the size, complexity and efficiency of the global financial markets, the Fed, or any central bank would have to engage in asset purchases far in excess of what the Fed has done to date to have a significant effect on long-term rates.
The Fed was able to control the federal funds rate because the market believed it could. But this had no appreciable or persistent effect on interest rates that matter for spending and investment decisions.
Pulling back the curtain on the Fed’s power is helpful because the false belief that the Fed can affect interest rates across the term structure has caused the markets to be overly sensitive to the Fed’s statements and actions. Recognizing that the Fed’s power to affect interest rates is limited will be helpful in that interest rates will respond more quickly and completely to changes in economic fundamentals without the interference from the Fed.
It also will be beneficial because it will force central banks to implement monetary policies that are in line with economic realities, not wishful thinking.
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.