The Federal Reserve Does Not Set Interest Rates
I'm going to get into a little bit of economic geekery here, because I forgot how many people don't realize this fundamental fact. I hear it from people all the time. And it's important to understand if you want to have any hope at all of grokking the economy.
The Federal Reserve absolutely, positively, does not set interest rates.
The credit markets do.
In a nutshell, rates go up when perceived risk in the economy is low, and rates go down when the perceived risk in the economy is high. Guess where rates are now.
The Federal Reserve is just a noisy spoiled toddler screaming at the top of its lungs that it's running the show. Like parents that don't realize that they're actually in control, we all stupidly listen to the spoiled brat and do what it wants. Not because we have to, but because we don't know any better.
Want proof? Grab a cup of coffee or two and read on.
The Federal Funds Rate is the rate which banks charge each other for overnight loans to balance their reserves. As with EVERYTHING in the markets, the price of this money is driven by... SUPPLY and DEMAND.
When private-sector demand for money goes up, the demand for inter-bank loans goes up and the inter-bank interest rate rises. Banks are able to charge more for their loans to other banks, and the Federal Funds Rate rises. When private-sector demand falls, the demand for inter-bank loans goes down and yield goes down. The Federal Funds Rate falls.
This is how the ACTUAL rate is set.
Now, what the Fed DOES do is set a Federal Funds TARGET. This is what they talk about on TV when they say that the Fed "set interest rates". The Federal Funds Target is what they would LIKE the rate to be. They have some amount of room to defend this target by adding or removing funds from the banking system, but when this cost gets excessive they have to move the target.
You can even see how they're doing at defending the target rate online. Before they cut rates to zero you could have easily predicted the cut because the effective rate had already been at or near zero for a long time. However, you can see an even more real-time picture by looking at demand for short term government debt.
You see, when banks aren't lending to the private sector either because of fear of default or lack of demand (2008 and 2009!) they invest in absolute safety: short-term government bonds. Private funds looking for safety also flee to government bonds.
Government bonds are considered the safest investment you can make. If you lose money on a government bond it means you're probably more worried about feeding your family and fending off bands of roving looters than the return on your investment. Bad news.
So when safety is desired over return, banks and investors flood into government bonds. The price of short-term government bonds (debt) rises, and yield (interest rates) falls. This is what happened over the past year. Everybody wants safety above all else--this is where the term "flight to safety" comes from.
To put it another way, when short-term government debt yields fall, banks are not lending money to the private sector. This is the exact OPPOSITE of what you would normally think--that more loans are being made because the interest rates are low. This is nonsense. When more loans are being made the interest rates rise. Banks and consumers set interest rates, not the Fed.
Meet the credit markets.
Now, with that in mind, take a look at this chart and tell me whether the bond market is leading the Fed or the other way around. Use a ruler if you have to ;)
This, by the way, is a chart from early 2008 that I managed to dig up. Proved to predict the Fed's moves pretty well, no?
Once again, the Fed does not set interest rates. The market does.
Its only tools are psychological.
Pay no attention to the man behind the curtain.
