I get this question a ton – who determines interest rates in the economy, the markets or the Fed? The answer is actually neither. The state of the economy determines how interest rates will be set.
It shouldn’t be controversial that the Federal Reserve could, in theory, control the nominal (not the real) rate of interest on US government issued debt. As the monopoly supplier of reserves to the banking system they can effectively set a ceiling on the interest rates of government liabilities by making a market in bonds.¹ Bond traders don’t fight the Fed because they know the Fed is the monopoly reserve supplier and can set prices just as they do with Interest on Excess Reserves.
Now, this gives the appearance that the Fed determines interest rates. But there are many more interest rates in the economy than the overnight rate or the rates on US government bonds. Yes, these are important benchmark rates, but they are just benchmark rates. Of the many markets for various interest rates the Fed only explicitly sets the overnight rate which serves as a key benchmark for other rates. Speaking of which, how does the Federal Reserve set overnight interest rates? In a system with an interbank reserve system, the Federal Reserve requires banks to hold a certain amount of reserves to settle payments. These reserves are always “excess” to the banks who would rather not hold these assets. As a result they try to lend them out to one another thereby putting persistent DOWNWARD pressure on interest rates. We often hear that the Fed “manipulates” rates lower, but the exact opposite is actually true. The Fed always manipulates rates up from 0% since 0% is the natural rate on overnight reserves. In today’s environment the Fed sets the overnight rate by establishing the interest rate on reserves. This incentivizes banks to hold reserves at that rate rather than lend them to one another at a lower rate. By setting the IOR rate the Fed is able to control the overnight lending rate.
Controlling the overnight lending rate does not mean the Fed controls the entire yield curve of debt. For instance, your credit card company does not merely set your interest rate at 0% because that’s where the Fed’s overnight rate is set. That rate is based on many other important factors like credit risk. The same basic thinking is true of all other types of interest bearing debts. The Fed has a precise control over very short-term forms of debt, but we can think of this control as being reduced as we extend the maturity into longer instruments. Imagine a man walking a dog on a long leash. The man has very precise control over the deviations in the leash at the base of his hand, however, as we move further out on the leash the variability in the leash is determined increasingly by other forces (like the dog). Importantly, the impact of those outside forces on long-term rates can force the Fed to alter the way it controls long rates.
Most importantly, it’s crucial to understand the context in which interest rates are set at a certain level. For instance, in an environment of high inflation the Fed is likely to respond to the state of the economy by raising interest rates. The Fed can’t control the economy and generally reacts to the state of the economy. In addition, the market rates on other interest rate products are likely to rise in a high inflationary environment even if the Fed were to keep overnight rates low. If a bank can charge you a higher real rate on bank loans because the economy is stronger then the difference between the benchmark rate and the lending rate just makes it more profitable for the banks to issue loans. This could also become inflationary and so the Fed is very likely to respond to a high rate of inflation by raising interest rates. Therefore, the Fed responds to the state of the economy.
The key point here is that it is the state of the economy which determines how markets and the Fed set rates. While the Fed sets the overnight interest rate directly (and could theoretically control all nominal US rates) we should not confuse this as being the same as the Fed controlling all interest rates. Instead, the Fed sets a portion of the interest rate market in an attempt to influence the broader economy. But the Fed does not control the economy or all interest rates in the economy so we shouldn’t confuse this control of some rates with being synonymous with control over all rates.
¹ – Why are Banks Holding So Many Excess Reserves? – NY Fed, 2012