It’s that time of the year again. Not the holiday shopping season—I’m referring to the rampant speculation over what might happen at the next bi-monthly Federal Reserve (Fed) board meeting on December 15 and 16. The amount of press devoted to these meetings and their outcomes is astonishing—almost as intense as the level of guesswork over what one of the Kardashians will wear to their next Hollywood event. The markets seem to almost stop in the hours leading up to the actual release, waiting on the results in breathless anticipation.
The “question” of course, is what will the Fed do on interest rates?
The Fed has been pursuing ‘stimulative’ policies since the ‘Great Recession’ began. The Federal Funds Rate (FFR) has been pegged at functionally zero since the start of 2008. At some point they will start to raise the rate. But does that mean you and I should care? Well, not as much as the markets or the press seem to. We might argue that this is largely a non-story for the vast majority of Americans.
First, we have to be clear about what ‘rate’ it is that the media are so interested in. The FFR, which is at the center of Fed interest rate policy, is an obscure number that relates to the cost of lending between banks within the Federal Reserve accounts on a day-to-day basis. It is not a rate that businesses or households will actually ever see on a bill or loan payment slip. The Fed does not directly set bond rates, mortgage rates, the prime rate, or the myriad of other percentages that are attached to loans in our economy. Market forces set all those rates—basically the supply and demand for lending capital.
This isn’t to say the FFR doesn’t have some impact on all these other rates, but the connection is far more obtuse than many realize. The graph below shows the history of interest rates for the 10-year treasury (the core driver of mortgage rates) and for the FFR. Both have been trending down over the past three decades. We can also see the cyclical aspects of the data—times when the Fed works to cool what they perceive as an overheated economy (FFR rises sharply) or tries to stimulate a sagging one (FFR declines sharply).
If you squint, you can see the ‘spillover’ from the FFR into the 10-year treasury rate. But it’s clear that the impact is nowhere close to one-to-one. To get a sense of how significant the pass-through is, the following table shows what happens to the FFR between policy turning points (when rates begin to rise or fall suddenly) and how the 10-year and 5-year treasury responds.
Over the last three cycles the Fed has tightened the FFR by an average of slightly over 3 percentage points. The average jump in the 10-year treasury for these increases was only six-tenths of a percent. Some of this has to do with the downward trends in the data. If we include periods when the FFR is falling, a 4 percentage point shift in the FFR leads to about a 1 percentage point change in the 10-year—a 1 to 4 pass through. The 5-year treasury is a bit more impacted, but the pass through is still less than 2 to 1.
What it all means is that even if the Fed starts to move rates sharply, there will only be small effects on the rates that we actually care about. If the Fed moves the FFR a full percentage point over the next year, this will increase 10-year treasuries by .25 percentage points and 5-year treasuries by .45 percentage points. This is not going to ramp up earnings on bond portfolios or have a significant impact on the housing market—the changes are simply too small.
But what if the Fed raises the FFR by 4 points or more? Well, they won’t. Indeed, they can’t. There is a functional limit on how far rates can go up. If the Fed pushes the FFR way above long-term rates it creates what economists refer to as an inverted yield curve, which is very tough on bank financials and can slow lending sharply. Extremely aggressive maneuvers are only used when the Fed feels the economy is really overheated—as they did in 2006, 2000, and 1989. And even in those cases, the Fed didn’t move the FFR much above long-term rates. So if the Fed thinks the markets are truly overheated, they will still only raise rates 2.5 percentage points, which would push 10-year treasuries up by .6 percentage points. This leaves mortgage rates well under 5%, very low relative to the last 30 years.
But the Fed doesn’t think the economy is overheated, nor should they. With GDP growth still below 3%, stagnant wage growth, and lending that remains subdued, they would think the opposite. This means small moves—which means even smaller changes in the rates you and I care about.
So why does the market care so much? Because people in the market think that other people in the market believe that still other people in the market do care. And in the big game known as market trading this means largely irrelevant things can take on a preposterously huge role in the media.
The FFR is truly the Kardashians of the financial world.