A commenter writes,
you can just look at a graph of the effective federal funds rate and see that (especially in recent years) it’s moved closely — in artificial-looking steps that are surely not the recent of some fundamental market rate process — with the FOMC’s target rate. You can then see that this rate and its near-term trajectory is transmitted almost one-for-one to short-term Treasuries, CD rates, etc., and that there is a heavy influence on mortgage rates, corporate bond rates, and so on as well. The extreme market segmentation needed for B clearly doesn’t seem to be there.
The fact that interest rates generally move together can be consistent with a number of hypotheses. One hypothesis is that the Fed influences all of these interest rates. Another hypothesis is that the views of the Fed are usually not much different from the views of markets. The question to ask is what happens when the long-term interest rate is X and the Fed thinks that it ought to be Y. Can the Fed move the long-term rate from X to Y? My impression is that the answer is in the negative.
Isn’t the 1970s proof that the Fed can not keep long term interest rates too low forever?
In terms of today, long term rates (as well as inflation) are low everywhere in the developed world so it is hard to simply blame the Fed here. That shows the economic long term investment opportunities are lower but I not sure what the main reasons are this? (Capital and especially IT Capital is very productive for the expeditures and Long term developed world demographics is lowering both AS and AD curves more than we thought.)
One way to think about this:
Repo rates and bank deposit rates follow Fed Funds fairly closely because these are all wholesale funding instruments. (The empirical evidence is clear per commenter Matt.) Essentially, the Fed controls the financial sector’s wholesale cost of funds – call it the “cost of goods sold” or COGS.
T-bills follow because they’re nearly interchangeable with repos and cds from the buy-side’s perspective.
The Fed’s influence on the long end comes from the financial sector’s response to changes in its COGS. The long end may or may not follow the short end because there are other factors involved, but that doesn’t tell me that the COGS is irrelevant.
For example:
If the COGS falls at the same time that long rates remain unchanged, banks may exploit their wider interest margins by ramping up the supply of credit (relaxing lending standards). In that case, the Fed influenced the real economy without relying on any particular correlation between, say, the 10 year Treasury and the fed funds rate. Control over the COGS can be a very strong lever.
It doesn’t seem to be done often, but I think you need to use forward rates instead of just using spot rates of longer durations to measure the relationship cleanly. And there, I think the idea that they move together is less clear.
Arnold:
You said (above):
“The question to ask is what happens when the long-term interest rate is X and the Fed thinks that it ought to be Y. Can the Fed move the long-term rate from X to Y? My impression is that the answer is in the negative.”
That is a very interesting question to ask. Not the least reason being that it leads to several other interesting questions. I would agree with your “impression”, as long as the Fed’s/FOMC interest rate policy alone is the influencing factor.
But the Fed has more (and more un-subtle) “tools” in its bag than just Fed Funds interest rate policy. For example, what would be the impact on long-term rates (relative to short-term) rates of the Fed altering Required Reserves in the financial system? Or for that matter altering the required make-up of those required reserves (Treasuries versus cash holdings.)?
I fully agree with you that the Fed’s (Fed Funds) interest rate policy at best, may influence, but not control, market interest rates – of any duration or risk profile. But I don’t believe Fed Funds interest rate policy/influence was never intended as a tool to “control” – in all respects or either duration or risk profile – market interest rates.