CFA Institute Journal Review June 2014 Volume 44 Issue 6
Does the Fed Control Interest Rates? (Digest Summary)
Review of Asset Pricing Studies
Architect of the efficient market hypothesis and Nobel Laureate, the author investigates the extent to which the Fed’s monetary policy controls short- and long-term interest rates. Evidence suggests that Fed actions with respect to its target rate have little impact on long-term rates, and there is substantial uncertainty about the Fed’s control of short-term rates.
The author considers the degree of control that the Fed exerts on interest rates, both short and long term. Although there appears to be some evidence of control for shorter maturities, and under certain circumstances, results for longer-term rates are inconclusive.
How Is This Research Useful to Practitioners?
The author questions the Fed’s control over interest rates, both short and long term. He considers the activity of a broad palette of interest rates relative to the Fed’s target federal funds rate. A critical issue is whether the US central bank is proactive or reactive when attempting to control interest rates and how the nature of its reaction may or may not achieve the desired effect. But the research presented does not really answer that question.
The author parses rate behavior over varying maturities. Despite the Fed’s efforts, market influences often seem to undermine the power of the central bank. But circumstances can make definitive conclusions tentative, no matter how many or how rigorous the tests. The persistence of low short-term rates in the wake of the 2007–09 financial crisis seems to buttress the argument that market forces triumph over the central bank’s accommodative policies.
The results of the author’s research, though tentative, would appear to support market efficiency. Financial academics, traders, and policymakers will find his conclusions both informative and thought provoking. A deeper understanding of the Fed’s power versus market forces could better inform trading and policy decisions.
How Did the Author Conduct This Research?
In the context of relevant literature on rates and term structures and to test his hypothesis, the author examines seven interest rates: the Fed funds rate, the target federal funds rate that the Fed sets, the 1-month commercial paper rate, 3- and 6-month US Treasury bill rates, and 5- and 10-year rates on US Treasury bonds. The data are from the FRED website of the St. Louis Federal Reserve Bank. Rates are observed for the time period of 1982–2012 and two subperiods, 1982–1993 and 1994–2012. The two subperiods consider the time before and after the Fed began to announce its target federal funds rate, which was in 1994.
Through the use of autocorrelations and plots of spreads over the target rate, the author demonstrates wide divergence in open market rates relative to the target federal funds rate. Furthermore, the divergence is larger for longer maturities. Autoregressions with error correction terms further document this disparity and the fact that it has nothing to do with the Fed’s target rate.
Regressions show that the Fed’s changes in the target funds rate are toward existing short rates. The extent to which a bank’s reaction is passive (letting the market dictate changes when inflation is under control) as opposed to active (controlling short rates when inflation or economic activity is not headed in the right direction) is not known with complete certainty. Finally, the author conducts an event study to examine current and future rate changes in an effort to determine how much short-term open market rates respond to unexpected changes in the target federal funds rate. Evidence of some Fed control would appear to occur at the short end of the yield spectrum but deteriorate for longer rates.
The author concludes that longer-term interest rate behavior would appear to be beyond the control of the Fed. A similar conclusion would appear to obtain for shorter rates. He does not place himself in either camp—the Fed or market forces—but one could infer the invisible hand of market efficiency at work. The decline in short-term interest rates over the past six years in the wake of the Great Recession would only seem to reinforce the author’s assertions. Market forces seem to keep these rates down despite the banks’ injections of interest-bearing short-term debt. Events seem to support the thesis for which the author is best known.
About the Author(s)
Marc L. Ross, CFA, is a senior compliance consultant at John Hancock.