Do you think it's the Fed?
It's not.
The market determines short term interest rates.
Really.
The Federal Funds Rate, which is set by the Fed, FOLLOWS 3 month T-Bill rates. It does not lead the economy. Here are some looks.Read it at Angry Bear
Who Determines Short Term Interest Rates?
by Jazzbumpa
Scott Fullwiler responds in the comment section:
STF said...Many believe this but it's the other way around. The tbill is based on expectations of the Fed since it's a 3 month rate and there can be a change in the funds rate that would affect holding period return. Just because statistically one comes first doesn't mean that's the causation. They should go read the Fed's transcripts and see how many times they say "the Tbill's moving so we have to change the funds rate." Doesn't happen.
Many believe this but it's the other way around. The tbill is based on expectations of the Fed since it's a 3 month rate and there can be a change in the funds rate that would affect holding period return. Just because statistically one comes first doesn't mean that's the causation. They should go read the Fed's transcripts and see how many times they say "the Tbill's moving so we have to change the funds rate." Doesn't happen.
ReplyDeleteI think the commenter Cameron has it right at Angry Bear - similar expectations story as Scott.
ReplyDeleteI suppose the market decided to set the base rate at 0.25%. Silly market.
ReplyDeleteI'm firmly in the time-travels-in-one-direction camp. If A precedes B, anyone who claims B causes A has some serious 'splainin' to do. Cameron's rebuttal of my Angry Bear post consists of some hand waving about prime interest rates and assertions about open market operations and expectations.
ReplyDeleteUnless the Fed is either making big moves specifically in 3 mo. T Bills, this is attempting to stage manage short rates via winks, nudges, and hints; then following up with a confirmation by adjusting the Fed Funds rate a week, month or quarter later.
If this fits your definition of the verb "set," then we are not reading the same dictionary.
Another possibility is that the Fed has a pretty keen idea of which way the head winds are blowing, and tries to keep its words and actions consistent with that knowledge. And in doing so, it is a close follower. Data supports this view.
I don't believe in time travel, but I do believe in Occam's razor.
Note also, as I pointed out in the A B post, that the biggest delays in Fed following T-Bills occur when there is a major change of direction. That is when Fed perception of the prevailing wind is least certain and they are the slowest to catch up.
I'm always perfectly willing to be proven wrong, but that requires actual proof.
Also, see Scott Sumner on this issueScott Sumner on this issue.
Cheers!
JzB
I already explained why you're wrong. It's well known that Tsy mkts price in expectations of fed funds rate--ever heard of futures markets and spot/futures parity? I tie my shows every morning before I go to work , but that didn't cause me to go to work.
ReplyDeletetie my shoes, that is
ReplyDeleteYes, the T-Bill markets price based on expectations - but it of the next fed funds rate set point, liquidity preference, anticipated inflation or what's happening in the general economy?
ReplyDeleteThe market is influenced by a number of cross currents.
You gave an assertion, not an explanation.
Futures markets are - hmmm . . . markets. And that is what I said is operating.
Cheers!
JzB
Ok.
ReplyDeleteThe Fed could buy every single bond out there tomorrow if it really really wanted to.
They could outbid anyone in the market dumb enough to bet against them.
They issue the currency.
They set rates, trust me.
Ok, I've just bought all the bonds. So you have loads of reserves earning 0%.
ReplyDeleteWould you like interest on those reserves?
Here you go.
That's your new base rate.
Thank you.
Paul Volcker made his point well about who sets rates.
ReplyDeleteJazzB let the cat out of the bag when he mentioned Scott Sumner as some sort of support for his argument - argumentation by appeal to authority, and Sumner's probability of getting something right is pretty low anyway.
ReplyDeleteI wonder why he thinks that bond yields have been declining steadily for at least 30 years? Is that what the Market™ demands?
Paul -
ReplyDeleteMy arguments are set out in my post and my comments, here and at AB. I made no appeal to authority with the link to Sumner, whose post I discovered after the fact and mentioned as an interesting addendum.
Please argue with me, not what you imagine might be going on in the nether reaches of my fevered brain.
Yes, in fact I do believe that reducing bond yields over the last 40 years is what the market demands. It's been secular disinflation and declining GDP growth over the period, so falling rates make a bit of sense, don't ya think? Or perhaps you believe that in the absence of Fed activity 3 Mo T-Bill would still be paying over 15%.
FWIW, I agree with Sumner on almost nothing. But Sumner's post, and the comments there, are interesting in its own right, the LIBOR digression not withstanding.
In particular, the three paragraphs of the comment by Catillonblog on 26 March @ 8:52 starting with: "Scott, I think you misunderstand the relationship between implied market pricing and Fed actions."
Nor is this an appeal to authority. it is recommending a well considered contrary viewpoint for your consideration.
Cheers!
JzB
Make that 30 years.
ReplyDeleteJzB
@JzB
ReplyDeleteIf you don't want to be thought a name-dropper don't drop names. Especially someone that is usually seen as wrong from the point of view of heterodox types.
There isn't much to argue with.
You've made a claim you can't prove other than through circular logic and and your argument is not compelling. I look at the same facts and come to a different conclusion.
It's a chicken-egg situation.
I see the declining rates over thirty years as coinciding with a huge increase in deficit spending. The common wisdom said that deficit spending would cause rates to rise. Not the case, another myth busted.
I wonder when you think the Market™ will demand higher rates?
Paul -
ReplyDeleteThere's a difference between name dropping and pointing out that another source has something relevant to say on the issue, and it might be enlightening to check it out. We'll just let the ad hominem go.
My claim is that the Fed Funds rate, set by the Fed, follows the 3 Mo T-Bill rate which is set by an auction. It has done so consistently for decades.
Please do me the favor of pointing out where I went circular. I'd like to avoid ever doing that again.
Nobody has addressed this:
Another possibility is that the Fed has a pretty keen idea of which way the head winds are blowing, and tries to keep its words and actions consistent with that knowledge. And in doing so, it is a close follower. Data supports this view.
Except the Fed tends to not get it quite right at major turning points.
Like I said, I'm willing to be proven wrong, but that requires proof. But nobody has put forth any serious argument against my contention. All I see are assertions.
I suppose the market will demand higher rates when there is a serious inflation threat, or borrowers think it makes sense to pay a higher rate, or at least have some greater incentive to borrow and drive rates up. But what I think doesn't matter, since I am not the market.
Cheers!
JzB
@ JzB
ReplyDeleteYou've shows some correlation but not shown causation, and there is the issue of major turning points, which is the marginal effect that is most interesting.
STF suggested that the anticipation shown by the market is "expectations," which is actually in line with what monetarists also assert as the mechanism.
Moreover, there is no evidence that it has been Fed policy to follow the market, in fact, the minutes of past meeting seem to indicate that they don't.
Since citing any reference in this venue is taken as appeal to authority, I might as well appeal to an actual authority.
ReplyDeleteThis Fed paper shows statistically that Fed Funds rates adjust to 3 Mo T-Bill rates, not the other way around. The FFR also adjusts to the CD rate.
After some nods in the general direction of expectations (as if they are loath to upset this revered apple cart,) they conclude:
"Nevertheless, the evidence presented here suggests that the relationship between the federal funds rate and other short-term interest rates is considerably more complex than models of monetary policy or the expectations hypothesis suggests."
Cheers!
JzB
Still correlation, not an explanation of causation.
ReplyDeleteLet's frame this correctly.
ReplyDeleteI am arguing against, not for causation.
We observe A precedes B.
Conventional wisdom is that B causes A, via expectations of what B will be, and what the Treasury will do.
I am arguing that B does not cause A.
Time's arrow supports this view.
A consideration of market complexity supports this view.
The Fed statistics I just cited support this view.
If there is contrary evidence, I've been unable to find it.
Cheers!
JzB
@JzB
ReplyDeleteOK, I'm open to that. The answer is then we don't really know for sure. I don't like "expectations" as a causal mechanism anyway, and I don't buy statistical justifications of causality either.
The fact is that the Fed does set rates for the reasons it determines. These may be different at different times, and certainly markets play a role.
What the extent of this role is remains to be established. If the data went the other way, with Fed setting leading the way, then the causal mechanism would be clear. But as you point out, that is generally not the case.
However, Volcker's jacking up rates, and the Fed's jacking up rates to quell inflationary pressure does not seem to be market determined. The market signals it wants the punch bowl taken away?