What does — and doesn’t — move interest rates?

There’s been quite a bit of volatility in the fixed income markets post election, and more than a little punditry about what the new administration may mean for the path of monetary policy in the US.

The immediate aftermath of the election saw rates sell off across the curve, with the long end (10s and 30s) leading the way to higher yields.

But the past week has seen tremendous volatility in the yield curve. 

Rates bear flattened after the Fed cut 25 basis points, then steepened out again after a round of inflation data.

The market can’t seem to make up its mind about the path of monetary policy under the new regime. 

We can’t predict the future.  But we do want to clarify some of the possible outcomes and cut through a bit of the noise and speculation.  

Who controls interest rates?

The Federal Reserve — the US central bank — decides upon a target overnight rate called the Fed Funds rate. 

To be precise: the Fed decides on a RANGE for that rate (typically 25 basis points, or 0.25%), then uses the tools at its disposal to ensure that rates stay within that range. 

Those tools include:

1. Setting a FLOOR on the effective Fed Funds rate by:

   a). Paying interest on reserve balances (IORB) deposited at the Federal Reserve by banks.  The Fed uses this tool to determine the FLOOR on the effective Federal Funds rate, but it can only be used by banks.

   b). Utiliizing the reverse repurchase facility (“reverse repo”). The Fed effectively borrows cash collateralized by bonds from other institutions aside from banks (i.e., money market funds) and pays interest on that loan.

2. Setting a CAP on the effective Fed Funds rate by:

   a). Utilizing the repurchase agreement (“repo”) facility. The Fed effectively lends cash collateralized by bonds and receives interest on that loan.

   b). Lending through the discount window — basically making short term loans to commercial banks where the Fed receives interest on that loan.

3. Impacting rates through open market operations

   a). Quantitative easing: purchasing bonds (i.e., US Treasuries, mortgage-backed securities) from banks in exchange for cash, increasing the Fed’s balance sheet.

   b). Quantitative tightening: selling bonds (or more typically, allowing them to roll off their balance sheet as they mature) and decreasing the Fed’s balance sheet.

You may have noticed that the Fed Funds rate is an OVERNIGHT rate. 

It is extremely short term, and the Fed has limited ways of impacting that one short term interest rate.

The only path to impacting LONG TERM RATES?  Open market operations.  

Quantitative easing — like the emergency measures we saw in the Global Financial Crisis or during COVID — increases the Fed’s balance sheet and can lower long term interest rates.   

Many people do not understand that even though we are currently in the midst of a Fed rate easing cycle, the Fed is in the midst of quantitative tightening right now.

They are allowing securities purchased during earlier years of open market operations to roll off as they mature.  

The long term impact of the Fed’s balance sheet expansion and the increased government debt issuance we’ve seen over the last 15 years is a massive issue that economists, politicians, and investors have grappled with for years.  

So when you hear pundits talking about the prospects for a new administration to simply raise or lower rates at will, you are now smarter than the average bear (pun intended) and will be better equipped to understand what is — and isn’t — possible within the current system of the US.