Look: I am eager to learn stuff I don't know--which requires actively courting and posting smart disagreement.

But as you will understand, I don't like to post things that mischaracterize and are aimed to mislead.

-- Brad Delong

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Everything that appears on this blog is the copyrighted property of somebody. Often, but not always, that somebody is me. For things that are not mine, I either have obtained permission, or claim fair use. Feel free to quote me, but attribute, please. My photos and poetry are dear to my heart, and may not be used without permission. Ditto, my other intellectual property, such as charts and graphs. I'm probably willing to share. Let's talk. Violators will be damned for all eternity to the circle of hell populated by Rosanne Barr, Mrs Miller [look her up], and trombonists who are unable play in tune. You cannot possibly imagine the agony. If you have a question, email me: jazzbumpa@gmail.com. I'll answer when I feel like it. Cheers!

Thursday, May 26, 2011

Who Determines Short Term Interest Rates?

Do you think it's the Fed?

It's not.

The market determines short term interest rates.


The Federal Funds Rate, which is set by the Fed, FOLLOWS 3 month T-Bill rates.  It does not lead the economy.  Here are some looks.  First the whole data set, going back to 1954, presented in Graph 1.

Federal Funds data from FRED.

T-Bill rates from a different Federal Reserve site

These are tabulated monthly values.  But the T-Bill rate is set in a weekly auction, and the Fed Funds rate is set by the Fed Open Market Committee, on an arbitrary schedule, at their discretion. 

Graph 1  Fed Funds and 3 Mo. T Bill Rates, 1954-2011

Not exactly lock step, but they are a couple of clinging vines.  At this scale, it's pretty hard to tell who leads and who follows.  Let's look closer at the last few decades.  First, the all-time highs of the early 80's, in Graph 2.

Graph 2  Fed Funds and 3 Mo. T Bill Rates, 1978-84

Here, the Fed Funds are in green and the T-Bill rate in orange, with the moves off of tops and bottoms highlighted in other colors.  Fed Funds tend to run a bit above T-Bills.  From this data, T-Bill rates generally change direction in the same month or the month prior to a Fed Funds change.

Graph 3  Fed Funds and 3 Mo. T Bill Rates, 1978-84

Same story in Graph 3: either concurrent motion or T-Bills are slightly ahead.  For the two downward moves at the beginnings of 1990 and 1995, they are three to four months ahead.

The story is similar for the most recent decade, shown in Graph 4.

Graph 4  Fed Funds and 3 Mo. T Bill Rates, 2000-2008

Looks like the Fed is a close follower of T-Bill rates, usually within a month or so.  Coming off a diffuse top, the lag can be a little longer.

Graph 5 shows a close up of 2001-5, without the odd colors.  T-Bill leadership is easily seen.

Graph 5  Fed Funds and 3 Mo. T Bill Rates, 2001-05

Two questions present themselves:

1) Does the Fed have any power to influence interest rates?
2) What would happen if they attempted to move counter to the market?

In my mind, this casts serious doubt on the usefulness of interest rate manipulations as a monetary policy lever.   What do you think?

Cross-posted at Angry Bear.


The Arthurian said...

Wow, thanks Jazz! I don't know what to think. I'm tempted to wonder why the Fed even bothers, then... Which leads me to wonder what's missing from the picture, and how you might have somehow fudged the numbers... NOT that I think you have.

I know that 50 million Frenchmen CAN be wrong, or 50 million economists, or whatever the saying is. Witnessed it in the autumn of '08, and since. Still, if it is so evident in the numbers, as you show, why is it such a secret? (I guess one could ask the same of my 'limbo' post.)

Dunno, buddy. At the moment, I still think the Fed exists for a reason, and there is a purpose to the FOMC meetings. What do YOU think?

Oh -- the numbers are probably not available... but in the 1970s there was an awakening of financial innovation; BEFORE the 1970s, when the economy was still good, finance was a much smaller part of GDP, and of life. I wonder if perhaps the Fed had the lead in those earlier years.

Jazzbumpa said...

Art -

I'm capable of making all kinds of mistakes, but I will NEVER fudge a number. And I always link my sources, if I have my wits about me.

The other parts of monetary policy are reserve requirements, interest on reserves (and excess reserves) and money supply manipulation. I do think the Fed has a roll to play, but I also believe that fiscal policy is much more potent - and that is what we will not do!

I was looking at GDP information today also, at BEA.

There is no easily identifyable finance component. Hmmmmmm.

That's probably because most financial transaction are mere enabelers when they're legitimate, and rent seeking when they aren't.


The Arthurian said...

Jazz... FIRST, I did not mean to imply that you might, or did, fudge anything. I am pretty good at fumbling the things I want to say. It's like: well these facts can't be facts, so where does the problem lie? I didn't for a minute think you were fudging anything. Maybe I was wishing you were :)

2. I did check your source links, just an inspection. One of 'em I never saw before, so that is a plus for me.

3. while I was out doing yard work I thought of something Milton Friedman wrote. He agrees with you about interest rates, I think. He writes:

The Fed has the power to control the quantity of money... But... the Fed has given its heart not to controlling the quantity of money but to controlling interest rates, something that it does not have the power to do.

I think I misinterpreted the Friedman statement in the past because I did not understand it. But now because of your post I think I understand the Friedman quote better. And he agrees with you.

Jazzbumpa said...

Art -

1) No offense taken.

2) Fed and BEA data sites are treasure troves.

3) Uncle Miltie and me -- kindred spirits fer sure.


Steve Roth said...

>There is no easily identifyable finance component. >Hmmmmmm.

Haven't you heard? Money is neutral. The financial system is a completely transparent and non-motive tally stick or bookkeeping system, like the bank in monopoly.

Take a barter economy, add a simplistic future-preference-for-money equation incorporating expectations, interest rates, and inflation, and you've completely modeled a complex financial economy.

Isn't it obvious? It's "like a diamond bullet..."