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Who Sets Interest Rates?

If you answered, “that’s easy, the Federal Reserve,” guess again!

The following statement is not true:

“In the U.S., interest rates are determined by the Federal Open Market Committee (FOMC), which consists of seven governors of the Federal Reserve Board and five Federal Reserve Bank presidents.”

Investopedia, “Understand the Role of the Fed”

Investopedia is not alone in being wrong. A simple search on “who sets interest rates in the U.S.” will often yield the same, inaccurate answer, over and over, an excellent example of how search engines spread misinformation, possibly for the rest of eternity.

Why are so many wrong? Why is this important?

Watch a talking head business news channel in the morning, and what do you see? The interest rate of the 10-year U.S. Treasury note, constantly changing every day the markets are open.

Given that the FOMC normally meets just eight times a year, how can it be that they determine interest rates that are constantly changing every trading day?

Obviously, they do not, and thus the inaccuracy of Investopedia’s statement.

Things get even more interesting if one considers that in the last month alone, from about Feb 19 to March 19, the 10-year Treasury note yield (another way of saying interest rate) gradually increased from about 1.3% to 1.7%. During this same period, the Federal Reserve, via the FOMC, did absolutely nothing, as the Federal Funds Target Rate has been stuck in the range 0.0% — 0.25% for over a year.

How important are the interest rates of treasuries? Very, like all other interest rates, including mortgages, car loans, credit cards, business loans, etc., will be higher than the corresponding treasury debt of the same duration or term.

As the interest rate of 30-year Treasury note increases, so will the interest rate of 30-year mortgage loans, possibly directly effecting you.

The Primary Market for Treasuries

Where newly created treasuries are sold by auction by the U.S. Treasury. Sold to anyone except the Federal Reserve, which is restricted from directly participating in these auctions. At best, a symbolic restriction, as will be later seen.

These auctions are infrequent. For 10-year notes, an auction is scheduled just once a month for the year 2021.

Will these once-a-month auctions influence the interest rates for all 10-year notes? On that day, absolutely. For the other roughly 20 working days a month, the secondary auction will establish the 10-year rate.

The Secondary Market for Treasuries

As established by a market, the interest rate of any debt instrument is determined by supply and demand.

This holds true for U.S. treasuries.

The “secondary market” is where the trading of previously auctioned treasuries takes place. The Federal Reserve, foreign central banks, financial institutions, and even private investors hold treasuries and actively trade them.

They could hold them to maturity, but as with all other financial assets, trading is common.

Most of this trading happens during the New York business day since the Federal Reserve of New York is the largest holder and trader of treasuries.

It is this secondary market that establishes the day-to-day interest rates of treasuries, which given the perceived low risk of treasuries, in turn, establishes the floor for the interest rates of all other domestic debt instruments.

The Supply of Treasuries

The supply is how many treasuries are in the market. Sold at auction, yet to mature. A dynamic amount in that the U.S. Treasury is constantly auctioning new treasuries at the primary market and buying back previously issued treasuries as they mature.

To accommodate an increase in the federal deficit, the supply of auctioned treasuries must proportionately increase. The value of new treasuries issued must exceed the value of treasuries maturing, equal to the dollar increase in the deficit.

As the supply of treasuries increases, assuming the demand is constant, one would expect the value of issued treasuries to decrease, corresponding to an increase in the interest rates.

The Demand for Treasuries

Who holds treasuries?

As the dollar is recognized as the most significant reserve currency, almost all foreign central banks hold treasuries. As does the Federal Reserve and most domestic financial institutions, because while banks may fail and cash lost, treasuries are always backed by the U.S. Government.

And they pay interest.

As interest rates decline, the value of all debt, including treasuries, increases. Thus, treasuries are a good investment in times of declining interest rates.

If interest rates are expected to increase, the opposite is true.

Special Demand & Supply for Treasuries, Open Market Operations

A possible stabilizing “fly-wheel” for this whole process is the Federal Reserve. If demand starts to drop for treasuries, the Federal Reserve can always buy more. If demand increases, it can sell.

In theory, a stabilizing influence on interest rates. In reality, to accommodate deficit spending, a politically motivated 30-year push to lower interest rates, until they could be lowered no more.

Exactly how does the Federal Reserve buy treasuries?

  • The Federal Reserve increases the M2 monetary base by increasing the credit line of banks that have accounts at the Federal Reserve.

  • In exchange for this increase in credit, the banks transfer to the Federal Reserve an equal value of prior purchased treasuries.

The net result at this point being a decrease in the supply of treasuries, increasing their value, lowering interest rates.

  • Empowered with this increase in credit, among other actions, the banks are expected to purchase more treasuries at the next treasury auction, or from the open market.

Which increases the supply of treasuries, depending on the amount purchased.

Allowing the federal government to continue borrowing.

This action of the Federal Reserve, purchasing treasuries from banks is called “open market operations.” What is so open about it is unclear, as very few understand how this works.

To raise interest rates (god forbid), the opposite process would occur, but do not expect this anytime soon as this will curtail the deficit spending of the government.

The Overnight Lending Rate and the Federal Funds Target Rate

While the rest of us are sleeping, in the wee hours, banks apparently are constantly loaning money to each other. This is a market all its own, with the interest rate of these loans, the “overnight lending rate” established by, you got it, supply and demand among the banks.

The Federal Reserve monitors this overnight rate and compares it to its preordained target inter-bank lending interest rate, which is called the “Federal Funds Target Rate.”

If the average overnight rate is higher than this target rate, then the Federal Reserve will magically increase all the bank’s reserves, which will lower the demand for overnight loans, which will lower the overnight rate.

(Sorry, there is no such thing as magic, but creating dollars from nothing is as close as it gets.)

If the average overnight rate is lower than this target rate, then the Federal Reserve will lower the reserves for the opposite effect. Yes, dollars will mysteriously disappear.

The goal of the Federal Reserve is that the overnight rate equals the federal fund’s target rate.

When the talking heads talk about the “Fed’s setting interest rates,” what they are really talking about is the Fed’s setting the Federal Funds Target Rate.

Not the same as setting interest rates.

As banks, in general, need to be profitable, the loans that they make to customers will have to have a higher interest rate than the money they are borrowing, so the Overnight Lending Rate / Federal Funds Target Rate can be thought of as the “bottom floor” for all interest rates.

And indeed, as shown in this graph, the Federal Funds Target Rate is sort of, kind of, the floor for the 10-year rate.

With many exceptions.

What about a Ceiling?

Good question.

While the Federal Funds Target Rate sort of establishes a floor, as can be seen in the next graph, the 10-year rate, as established by the secondary market, seems to recently have a mind of its own, increasing even though the Target Rate is constant.

What can and should the Federal Reserve do about this unplanned interest rate increase?

The only thing the Fed’s can do is increase demand for treasuries via Open Market operations. Increasing the M2 Money Supply as it buys more treasuries, which by the looks of the M2 Money Supply, perhaps is exactly what it has been doing…

What happens if rates keep increasing? Should the Federal Reserve keep buying more treasuries, increasing the M2 money supply? Perhaps even accelerate the rate that it is buying treasuries to accommodate the increase in deficit spending (thank you, so-called Covid Relief spending package).

That is the multi-trillion-dollar question.

Yes, it can.

But should it? Recall the well-established long-term relationship between the M2 Money Supply and inflation…

Could it be that this dramatic recent increase in M2 that has stoked inflation fears, the very same fears that are dampening the demand for long-term debt such as the 10-year note, that in turn is causing the recent increase in interest rates, forcing the Fed’s to buy even more treasuries, pushing up M2 even more…

Has the Federal Reserve painted itself in a corner, trying to accommodate the massive increase in deficit spending? How should it respond if higher inflation dramatically reduces the demand for all long-term debt instruments, pushing up interest rates?

Caution: If you are holding long-term debt in your investment portfolio, they will lose value if inflation/interest rates increase…


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