Interpreting the Fed: How Did it Lower Rates This Time?

Photo: snowlepard

I’ve found a lot of the recent discussion about the Fed to be, frankly, confused.  So I thought it worth trying to put the issues into a broader context.

Read the Fed’s latest statement, and you’ll see many of the themes I’ve talked about recently.  They’ve learned that the economy is not only weak, but that—as I’ve been forecasting for some time—“economic growth so far this year has been considerably slower than the Committee had expected.” Turn to the labor market, and they somewhat dryly note “a deterioration in overall labor market conditions.” And while they won’t use the word double dip, they do note that “downside risks to the economic outlook have increased.” Also, “inflation has moderated.”  So there’s plenty of room for them to try to goose the economy.  But how?

Typically, the Fed does this by reducing the Federal Funds Rate, which is an interest rate on overnight loans. Unfortunately, that short-term interest rate is now pretty much at zero, and can’t go any lower. The thing is, no-one actually cares about the Fed Funds Rate. You and I and the businesses we work for don’t borrow using short-term interest rates.  Instead, we finance our investments with longer-term loans.  The Fed Funds Rate only matters to the extent that it reduces long-term interest rates.

So the key is for the Fed to reduce long-term rates.

Recently, the Fed has been doing this by “Quantitative Easing.”  It’s a terrible name for a simple solution. Just as the Fed adjusts short-term interest rates by buying and selling overnight government securities, it can adjust long-term interest rates by buying and selling long-term government securities. That’s what QE2 did.

Many market commentators are disappointed that the Fed didn’t announce “QE3”—a renewed round of quantitative easing. But they shouldn’t be. The Fed still chose to reduce long-term interest rates, they just decided to do it with a different tool. They figured that if you can’t reduce short-term interest rates further, you should reduce ‘em for longer. That’s what the Fed was promising, when they said they expect to keep their short-term rate at “exceptionally low levels for the federal funds rate at least through mid-2013.”  What does this do? Keeping short-term interest rates lower for longer will also reduce long-term interest rates. And that’s the main game. It has already worked—perhaps even more reliably than following QE2. The interest rate on two-year bonds is down to virtually zero, and the 10-year interest rate is down to 2.2 percent.

So yes, we got lower long-term interest rates.  That’s what matters. And it doesn’t really matter how we got there.

If there’s anything to debate, it’s whether the Fed has done enough to stimulate investment.  My bet is that they haven’t, but I think yesterday’s announcement was a useful down payment.

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  1. Jenn says:

    THANK YOU for this direct and easily read explanation. As a potential homebuyer (in the next year or two) this eases my mind considerably.

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    • Phillip says:

      Jenn – I’d be cautious about what you purchase. If you can get a good “deal” then it may be worth it.

      Know that with the inflation that our central bank is causing, the cost of living is rising significantly. So while the cost of housing and interest rates will likely stay low (relatively) in the next year or two, the cost of living will more than likely offset these low costs.

      What do I mean by this? All the things we need to purchase to survive as humans is likely to increase in the next two, three years. In the past month our water bill has doubled. The cost of food I’ve seen go up by 10% in the past two or three months. Gas prices are likely to continue to rise in the next year. Energy costs have increased and are likely to continue increasing.

      This site has a few articles that may interest you. Anyways, take care.

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  2. jonathan says:

    Good points. and as has been noted elsewhere, that nominal 2.2% on the ten year implies a real rate of %0.0.

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  3. jonathan says:

    Or, the expectation in the markets is that the Fed will need to do more and thus will do more, meaning they trust the Fed won’t twiddle its thumbs as the nation’s economy slips away. The Fed has not in the past refused to act when necessary, so the rational expectation is they will act. These rates may reflect that expectation and that would not be such a good thing because the expectation is for a lousy economy. In other words, the rates may reflect both the expectation the economy will worsen and that the Fed will act.

    BTW, I think the Fed isn’t doing much about jobs because it can’t move short-term rates and that is their usual tool. I think they feel hamstrung.

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    • caleb b says:

      “BTW, I think the Fed isn’t doing much about jobs because it can’t move short-term rates and that is their usual tool. ”

      The FED can’t do anything about jobs unless it hires people directly. The private sector will hire more labor when the demand for goods and services (G&S) increases to a point where more labor is required to deliver those G&S.

      If you mean increase the money supply to encourage banks to lend, well, what they give with one hand, they’re taking with the other. The FED is encouraging lending, but the FDIC and OCC are discouraging it, by being overly cautious on capital requirements.

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  4. John B says:

    No matter what you call it, it is merely moving deck chairs around on the Titanic.

    Hot debate. What do you think? Thumb up 17 Thumb down 14
    • John B says:

      When I posted this, I thought it was a very mild criticism. So when I had such a high dislike that the post was blocked, I was stunned.

      Thank you to the 13 people who liked this–the point of a site like Freakonomics is to actually think and examine issues, not just react negatively to anyone who disagrees with the powers that be.

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  5. do says:

    Who cares about overnight rates… banks do.

    A steep curve is stimulative. It encourages banks to increase thier leverage, borrowing short and lending intermediate and long. But what if banks are already pushing their leverage limits. This puts the Fed “pushing the string.” The Fed is making money available but no one is taking it.

    With Fed funds near zero, not much they can do to lower the front end of the curve. And, buying down the back end of the curve may actually be couterproductive.

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  6. Mary says:

    Why do we have a fed ? I truly don’t understand and I’ve worked in finance for 20 years.

    Didn’t the Soviets try using central planners to run the economy?

    Isn’t Quantitative Easing just printing money which is essentially stealing? My savings are watered down by the fed by printing more money.

    Where am I wrong here ?

    Are we seeing the end of the Fiat currency era ?

    Well-loved. Like or Dislike: Thumb up 15 Thumb down 10
  7. Currymeister says:

    Hello…A direct and great post.

    Well, I am skeptical about QE and the reduction in the Federal Funds Rate. Firstly, we must agree that interest rates are just another name for a price. A price for a loan. Most of us agree, I hope, that maximum prices on goods and services would cause excess demand. Thus, this excess demand in the realm of interest rates will not bode well for the economy.

    With excess demand by consumers there should be an automatic mechanism (which there would be) to increase interest rates as bank reserves fell. Yet, with the FED consistently buying treasury bonds to keep interest rates low then it will spiral mal-investments. These types of investments would have never been made and eventually it will bring the economy down to its knees as people the market tries to liquidate these bad investments.

    This chain of events caused the financial crisis and unfortunately we still seem to be prescribing the same medicine for the economy. The mal-investments were put into the housing market, and when the bubble burst we blamed everything else…But, the heavy intervention on the interest rates.

    I do hope we get a sustainable recovery in the future…

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  8. David X says:

    Of course, lowering the rate is pointless if you can’t get anyone to purchase the bonds, so go ahead and crash the market to drive the sheep toward the pen. It could be a regular event until the sheeple figure out that gold is a good haven under financial repression.

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