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February 2002; Volume 20, Number 2

What the Fed Canít Control

by Christopher Mayer

With Greenspanís widely reported "rate cuts" this fall, most people would probably be surprised to find out that the federal funds rate is not set by Greenspan. It would also probably surprise these same people to learn that only weeks after short-term rates hit rock bottom, longer-term rates rose steadily. 

Conventionally, one of the Federal Reserve Bankís roles is to lessen financial crises by acting as a lender of last resort. In other words, the Fed is supposed to stand ready to provide fresh reserves to banks in need of cash. This lending of reserves is called discount window lending, and the interest rate that the Fed charges banks for these reserves is called the discount rate. This is the only rate that the Fed "sets."

The discount rate itself is not as important as the federal funds rate, because very few banks go to the Fed to borrow money. Indeed, the only ones that do so are typically on the verge of collapse. Banks in need of reserves will go to other banks with excess reserves before they go to the Fed.

This is where the federal funds rate comes in. The federal funds rate is the rate that banks charge each other for reserves. It is poorly named since it is not a rate that the Fed charges. Therefore, the federal funds rate fluctuates frequently in response to the supply and demand of bank reserves. 

This is not to diminish the Fedís role in influencing this rate. For, while it does not actually set the rate, it does have a strong influence in what that rate is by buying and selling government securities. 

For example, if the Fed wants to increase the banking systemís reserves and drive down the federal funds rate, the Fed will buy government securities on the open market. By buying these securities, it gives the seller cash and takes the securities. This cash, then, finds its way to the banking system, and banks suddenly have more reserves. 

Conversely, if the Fed wants to take money out of the system, it can sell government securities, thereby taking in the cash and replacing it with government securities.

All of this has a large impact on short-term rates. When Greenspan announces another one of his "cuts" (which really means that the Federal Reserve has lowered its fed funds target), short-term rates fall. 

However, long-term rates may behave entirely differently. The actions of the Federal Reserve can have a dramatic influence on longer-term rates, but influence and control are very different things.

Long-term rates may rise, in spite of the Fedís attempts to bring down rates. In fact, this has begun to happen. During the week of November 12, bonds sold off sharply, which means their yields rose. The Wall Street Journal reported that it was the worst bond sell-off since 1987. 

One of the bonds thought to be the most sensitive to Fed policy is the two-year Treasury note. Since hitting a record low of 2.30 percent on November 7, the two-year note has risen to 3.05 percent since then, a 33-percent increase. The thirty-year bond yield has risen some fifty basis points during this time to 5.27 percent.

Why can longer-term rates rise even in the face of the Fedís efforts to lower rates? Many bankers, investors, and economists spend a lot of time interpreting the yield curve, which is a chart that simply measures interest rates on a vertical axis with time to maturity on the horizontal axis. The curve is typically upward sloping; meaning longer-term rates are generally higher than shorter-term rates.

We know that future goods trade at a discount to present goods. In other words, given a choice, people will always choose to have a given thing now as compared to having the same thing a year from now. This discount that future goods trade against present goods is driven by consumer preferences and is not readily identifiable by looking at the interest rates for loans. 

This underlying interest rate is always present, but the influence of money complicates things. For example, there are times when short-term interest rates can be higher than long-term rates. How can one explain this? 

The dominant theory to explain what is called the term structure of interest rates (which is a fancy way of referring to the fact that interest rates vary with the time of the commitment) is the Expectations Theory of interest rates. This theory states that longer-term interest rates should be set so that an investor would be indifferent between holding a long-term bond or a sequence of shorter-term bonds covering the same length of time. 

Without getting too technical, letís just say that theory states that people take into account what they expect the future to be when borrowing and lending money, and that these views get incorporated into the term structure of interest rates. Letís also say that interpreting the yield curve is a murky, debatable business with many opinions as to why things are the way they are at any point in time. 

Nonetheless, if people believe that recent Fed policies are "inflationary" (that is, that prices are going to rise in the future), then the yield curve will be upward sloping and will get steeper as people will demand a higher interest rate to compensate for the expected loss in purchasing power. 

When the yield curve turns negative (when short-trm rates are higher than long-term rates), that too embodies the expectations that investors are setting for the future and is also a consequence of the Fedís manipulating short-term rates. A negative yield curve is not very common, though we had one for a while early in the year. 

So, longer-term rates embody expectations about the future and are determined by savers and borrowers in the market. As a commercial lender, I often receive a number of calls during a day in which Greenspan and Company announce a "rate cut." Customers and potential borrowers always ask what the new interest rate is on a 5-year equipment loan or on a 15-year real estate loan. And these folks always seem surprised when I tell them that the rate didnít move much or actually went up. They donít understand that interest rates are determined in the market and not by the Fed Chief. 

Next time Greenspan talks about cutting the federal funds rate, keep in mind that what he is doing is changing the target and signaling where monetary policy is headed. Also know not to expect a commensurate drop in long-term rates, since these rates embody expectations and these rates are still set in the marketplace. The Fed is powerful but not omnipotent.

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Christopher Mayer is a commercial lender and a frequent contributor to (


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