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Who Determines Interest Rates?

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

  1. Suvy

    I spoke about this in one of my post where I explain the three different kinds of monetary systems. A central bank can peg the money market rate of interest, the monetary base, or the rate of exchange in FX. As of right now, the Fed isn’t pegging the money market rate of interest because it’s setting the monetary base.

    With regards to the Fed pegging an entire yield curve, I’m not so sure. The problem is that if you try to hold your 10 year at 1% while NGDP is growing at 10%, you’re not in very good shape. The yield curve can be pegged during certain times (as it was in World War II), but they require price, wage, and asset market controls of some kind–and all of which were done during World War II.

  2. tealeaves

    As a corollary to this topic you may want to talk about the myth of “who” controls the money supply? The notion that Bernanke or now the Fed, is standing ready “firing” up the printing presses and dropping freshly minted money from helicopters is a commonly held belief. I’d guess the answer is that market demand sets the money supply which is influenced indirectly by Fed through interest on reserves and base money.

    On a practical level, do investors really need to care about the growth in money supply. Or rather should they focus be on interest rates (on reserves).

  3. Dennis Kleid

    I think we all know that too much credit chasing overpriced assets is maybe the main cause of inflation. How does the raising of interest rates, by the Fed in particular, slow credit creation? I say it doesn’t. Even though the Fed rate is at the bottom of the totem pole, it raises the profits for banks and non-bank lending institutions, and brings forth the marketing of credit. Since lending is a much more profitable enterprise when rates are high, it causes more of a rise in the interest rates because supply and demand in this business is upside down. The higher the rates the more marketing there is. Thus, more marketing begets more loans being funded to unworthy borrowers chasing overpriced pipe dreams. The higher the rates go, the more marketing until the rates become so high that we finally have no borrowers, and thus a crash. I say, low rates forever…..

  4. Kris

    What should be the fair interest rate? I think TIPs may provide a hint. I think it is “Inflation rate + 3%”. Is that fair and on what basis TIPs interest rate was determined? I would really appreciate if someone dig deeper into this subject and enlighten me/us.

  5. pliu412

    I think it is not the question of WHO and it is the question of HOW.

    How Fed determines interest rates? What factors Fed considers behind door?

    I would think Fed will consider the following aspects :
    1. Economy
    2. Foreign US debt payments
    3. US currency (maintain reserve currency status advantage) (this would be mixed with Gold and Oil prices and weak/strong dollar, import with more trading partners using US dollars)

    Item 1 is more domestic issue, and items 2 and 3 are more geopolitical and financial warfare issues.

  6. Suvy

    The Fed raising short term rates absolutely reduces inflation. Long end rates are effectively NGDP expectations (plus a risk spread) and NGDP growth is the growth of real assets. When the Fed raises the money market rate well above the long end interest rates, an economic slowdown occurs? Why? It’s because banks effectively borrow short and lend long and remember loans create deposits. Why would anyone issue a loan if they’re paying out more on deposits than they’re getting from the long end of the curve.

    Also remember that the money market rate of interest is the price of liquidity. By raising short end rates, the Fed effectively reduces the amount of liquidity. This can create problems in the banking system.

  7. John Daschbach

    The “fair” interest rate is pretty easy to get in the long time limit. The real rate of return on all assets can’t exceed the real growth rate. The slope of mean nominal return vs. risk has to be positive which requires that the distribution function over real returns is required to have low risk assets with real rates lower than the real rate of growth. TIPS have only risk in the growth expectations term. The 10yr has the growth expectations risk plus inflation risk. Except for early 2008 to mid 2009 the difference has been remarkably constant at 2.1%, or the target inflation rate. To estimate what the “fair” yield look at the TIPS yield is vs growth rate, pre-crisis. and it’s ca. 1% below real growth. The long term trend has this level widening, as it should for many reasons. My guess is it will be around 1.5% below real growth over the next decade or more. It’s optimistic to think we will get solid 3% growth over the next decade and probably optimistic to think 2% inflation will be the norm. I’d say it’s most probably 2 to 2.5% growth and 1-2% inflation. So a fair yield on a 10 yr today is from 1.5% to 3%, not inflation % 3%.

  8. Dennis Kleid

    Logically, sure higher rates should reduce inflation. But you’re not considering the flood of cold calls from Loan originators. If this marketing push didn’t work, why would the loan originators spend so much mooolah paying cold-callers to do this. You’re not considering the profit motive when rates are high, and the fact that these folks can never run out of liquidity, can they? They can sell the loans docs for cold hard cash, but only if the ARMs will pay high rates. I think in practice causing loan rates to rise CAUSES inflation because of marketing by the loan originators, something that does not exist today because the profits are way down. Since 2009 overall credit creation was way low. This year we may finally see this mooolah creation and investment working for us again.

  9. Kris

    Thanks John. If I understand you correctly, “fair” interest rate in the long-term (10 years or more) should be about rate of growth? We need to take current TIPS rate is somewhat abnormal?
    Is there a good paper I can read that explain in simple terms the relation between interest rate vs inflation vs growth. Thanks again.

  10. John Daschbach

    The “fair” nominal yield on assists with only growth risk (the economy does much better than predicted) are required to be lower than the growth rate over the long term (that is the First Law of Thermodyamics projected onto economics). How long is the long term? I have no idea. The capital “hoarding” limit is when the producers of output (workers) can no longer sustain life (e.g. some starve to death). The capital “worthless” limit argues that people will never move above equilibrium (substance level for a given population) because there is less than zero advantage (in aggregate) in taking risk over lending to the government at zero risk (other than growth).

    I’m sure there are papers that try and explain it in simple terms. But it’s not that hard to derive. The real economy is people working (convoluted with their productivity). Everything else is derisive of this.

  11. Suvy

    They can do that as long as liquidity is expanding. Once you see liquidity start to contract, things change. Remember that the trigger that ended the housing bubble was Greenspan starting to raise rates from mid 2004 to mid 2006. Late 2006 was when the bubble really starting going the other way. Once liquidity starts to tighten, credit becomes very difficult to expand because people have difficulty making payments.

  12. Karl

    Interest rates are the main cause of inflation so increasing the rate only leads to higher inflation. The cost of interest is a major cost component of almost everything we consume today. Higher interest costs are ultimately passed on to the final consumer. Why is money created out of thin air lent to us at interest?

  13. Dennis Kleid

    2008 is when the folks really stopped paying on their loans and the value of the loan papers crashed, bringing virtually all banks and loan institutions that decided to hold the papers in technical bankruptcy and thus 0 liquidity. I think the bubble was “pricked” by the speculation in crude oil prices pushing them 2x from the year before. Folks had a choice, gas or mortgage or move back to Mexico and abandon their properties. The loan papers were long since sold off for cash by the originators, except a few dumb ones Countrywide, E-Trade etc. Greenspan’s policy is blamed for a lot, but the marketing of credit to unworthy borrowers, buying two or three over priced homes WAS the cause of the price inflation. The oil prices put the borrowers in a tough spot and down everything came. Your theories are fine, but the unexpected drives the bubbles to pop. This one was predicted: Release date: 02/01/2004 THE OIL FACTOR: Protect Yourself—and Profit—from the Coming Energy Crisis Stephen Leeb, Donna Leeb Authors

  14. Suvy

    The crisis started in early 2007 when the first banks started to go bust (the first bank was a French one). It just takes time for the knock on effects to take place.

    The “speculation” in commodity prices always happens during international financial crises. It gets blamed, but it really shouldn’t be. The crisis was an international one, not a US one. Treating the crisis like a domestic one will lead to major errors.

  15. Dennis Kleid

    The USA banksters floated our loan papers all over Europe, dragging them down as well. Greenspan’s raising the rates CAUSED more credit creation by loan originators, and margin credit CAUSED the oil prices to go up and out of control. In spite of the logic, credit creation grew tremendously in 2006 in 2007 and in 2008 then pop. Look at Kalecki profits chart. I wish I could post it here.

  16. John Daschbach

    Typical Suvy, making bold statements that are not always correct. There is no absolute effect which anyone can see by looking at the data. The economy is complex and this is evident in the data and anyone who makes statements like Suvy does is just showing a lack of critical thinking.

    The early 70’s FF increase precedes a large unemployment increase but inflation didn’t decrease to any significant degree. The late 90’s increase preceded a large unemployment increase but inflation increased slightly during this period.

    There is a huge literature related to inflation, with a multitude of models proposed. How is it that Suvy “knows” and thousands of researchers don’t?

  17. Suvy

    I think it’s funny that you’ve got a middle aged man personally attacking someone in his early 20’s on some website. Keep it up because you’re quite the role model.

    With regards to inflation and interest rates, there’s always a lag and it’s not anything new (or rocket science) to say that a yield curve inversion can put pressure on a banking system.

  18. Suvy

    I wish our bankers sold more crap to the Europeans to be honest. Not being a sucker is an important thing in the world. If our bankers exploit suckers halfway across the world, that’s not our problem. If they exploit our own citizens, it’s a completely different issue.

  19. Suvy

    Credit to unworthy borrowers is gonna happen. It always happens during international crises. By the way, commodity prices ALWAYS rise and crash during international cycles. It’s nothing new. It’s not commodity price runups that cause these cycles. They’re just symptoms as is Ponzi finance.

    The real problem has to do with structural shifts in the world’s economic system. You showed me a chart of the balance of payments without realizing that the US was having massive current account deficits which is the same thing as a capital account surplus. In other words, you’ve got the world’s most capital rich country importing capital and expanding liquidity. If you’re rich in capital and importing capital, you’re gonna have asset bubbles. What else are you gonna do? The real problem is that the dollar is the world’s reserve currency, which forces the US to run persistent current account deficits as other countries have to accumulate dollars in order to make payments. What we need to do is to remove the Fed and watch the dollar fall in the FX market. That’ll fix US unemployment and lack of demand overnight.

  20. Dennis Kleid

    You’re pointing out some of the bumps in the road that make economic models a bit difficult. I think these macroeconomic theories are good to see what should happen logically. When there is a deviation from that logic, then we need to dig deeper to noodle this out. I think our FED’s writers and researchers are doing a lot to bring this into focus. We may not have a boom and thus burst for a long time as long as the rates stay low and the credit marketers are out of work. https://www.federalreserve.gov/publications/budget-review/files/2013-budget-review.pdf

  21. Suvy

    You’ll always have boom and bust unless you can change human nature. Everything in the natural world is cyclical and economies are no different. Economies adapt to their surroundings and economic systems codevelop with other systems. In other words, their behavior is much closer to an ecosystem than it is to a car or any other man-made object. They respond to volatility. If you remove the volatility (what Greenspan did), you may get a short term benefit, but you’ll exacerbate the underlying problem.

  22. Suvy

    By the way, there won’t be an energy crisis. Something else will happen before we reach that point (probably war). We’re already working on 3-D printing solar panels and finding other forms of energy. If you see oil prices go up a bit more, you’ll see these alternatives being taken up. That being said, commodity prices are collapsing as we speak. With the world in a depression, expecting commodity prices to spike is stupid. Commodity prices are economic inputs. If economic activity starts falling, commodity prices will fall as well.

  23. Dennis Kleid

    Suvy, So you’ve gone out of the topic of trying to noodle out our present situation to prescriptions for changes that we have little (actually no), say in. Suvy: “What we need to do is to remove the Fed and watch the dollar fall in the FX market. That’ll fix US unemployment and lack of demand overnight.” Sorry I got into this……

  24. Suvy

    I’m not noodling out of anything. How come “deregulation” has been a problem with financial systems for centuries? How come we often see worse crises in highly regulated, centralized financial systems (the US is no exception BTW)?

    Any system that relies on bureaucrats and politicians making decisions about things they do not understand whereby they do not suffer the consequences of their actions is wrong. It’s that simple.

  25. Dennis Kleid

    I know, and agree with this a lot. The question was “who or what” is in control of interest rates in the situation we are living with? You’re off topic.

  26. Suvy

    Fair enough.

    As I said, the Fed controls short term interest rates. Long term interest rates are dependent on NGDP expectations.

    I don’t know if loan rates rising CAUSES inflation because there’s feedback loops. It’s not surprising to see high rates with high inflation, but the causality is weird. There’s also a difference between the short and long end of the curve. If the short end stays flat while the long end is rising, there is a profit opportunity available that allows people to short the short end of the curve and long the longer end of the curve by holding real assets.

  27. Dennis Kleid

    OK My only point, which I think is something different from the models, is that the “feedback loops” need to be reconsidered.

  28. Kris

    John, Most developed economies seem to follow “Taylor Rule”.

    “Taylor explained the rule in simple terms using three variables: inflation rate, GDP growth, and the interest rate. If inflation were to rise by 1%, the proper response would be to raise the interest rate by 1.5% (Taylor explains that it doesn’t always need to be exactly 1.5%, but being larger than 1% is essential). If GDP falls by 1% relative to its growth path, then the proper response is to cut the interest rate by .5%.”

  29. Willy1964

    – Mr. Market determines rates, both short term & long. And the FED follows.
    – The last time the FED didn’t follow the market was in 1981,
    – The next time the FED won’t follow market rates is when (not if) Yellen raises rates in order to protect the US financial system from imploding.

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