The year 2019 was a year of declining market interest rates. In November 2018, the 10 year treasury rate was as high as 3.24% and then it declined steadily through the first eight months of the year, reaching 1.47% at the beginning of September 2019. Importantly, the Fed had raised its upper bound target for the Federal Funds Rate (and the interest rate on excess reserves, or IOER) in December 2018, and held it constant until the very end of July even as the 10 year rate was declining. So much for Fed control of market interest rates. The 10 year rate was 2% at the end of July, when the Fed reduced the target for the Federal Funds rate by 25 basis points, and the 10 year rate continued its decline by just over 50 basis points. The 10 year treasury rate continued to decline by just over another 50 basis points until the end of August. After the early September low, the 10 year rate started to gradually increase despite two subsequent 25 basis point cuts in the Federal Funds Rate target at the September and October meetings. Since early September, the 10 year rate has increased from 1.47% to 1.77%.
This pattern is shown in the accompanying graph. While the Fed raised rates and held them constant for more than half a year, the general level of market interest rates fell, and not just at the long end of the term structure. The 3-month rate was at 2.4% during the first five months of 2019, but then began falling in early June and was down to 2% by the time of the July FOMC meeting. The 3 month rate continued its decline until the October FOMC meeting, reaching a low of 1.49% just after the October FOMC meeting.
While the popular press, and many economists, talk about the Fed as ‘setting’ interest rates, the reality is quite a bit different. The Fed has not ‘controlled’ or set the broad set of market interest rates. On the contrary, market interest rate movements have influenced Fed behavior, albeit with a lag. The Fed has been a market follower during this period, reducing the Federal Funds Rate target (finally!) at its July meeting, and then following up with two additional reductions. The Fed, eventually, followed market interest rates down during 2019. The Fed was not so much the leader of falling market rates as it was the reluctant follower.
What does it matter that the Fed kept the Federal Funds Rate target constant through the first seven months of 2019 without lowering the Federal Funds Rate target? The problem is that the closely related administered rate, the IOER, was equal to and then above the interest rate on Treasuries, even 10 year treasury rates. The interest rate the Fed sets by fiat, the interest rate it pays to banks for holding reserves, was above the short term market rates many months. Even now, the IOER is essentially equal to the 3 month Treasury rate. Banks are being encouraged to hold excess reserves instead of buying Treasury bills or otherwise placing their reserves into circulation.
The following figure shows that as of December 6, the IOER is 2 basis points above the 3-month rate, 2 basis points below the 1 year rate and 29 basis points below the 10 year Treasury rate! During 2018, a year of rapidly declining bank reserve holdings, the 10 year rate averaged 102 basis points above the IOER and the 1 year rate averaged 44 basis points above the IOER. Given what has happened in the last six months, it is no surprise that bank reserve holdings are rising. These rising bank reserves put extreme pressure on the ability of the Fed to reach its inflation goal.
Another interesting development is the interest rate inversion that occurred in May, when the interest rates on short term securities began to exceed the 10 year Treasury rate. This inversion finally rectified itself in mid-October. Importantly, interest rate inversions preceded the last three recessions. While the inversion has now disappeared and some suggest that the recession danger is now over, we should all remember that while interest rate inversions preceded the last three recessions, those inversions ended months before those recessions began.
That said, there is no consensus regarding the causality of interest rate inversions to recessions. Indeed, the inversion may be better thought of as indicating market participants’ expectations of a coming slowdown in growth rather than as some sort of direct cause of a future recession. Be that as it may, concern over slow future growth would seem to suggest an expansionary monetary policy is in order, which requires putting additional reserves in circulation.
What Should the Fed do in December?
Because of the continued lack of market yields above the IOER, banks have increased reserve holdings. The Fed is again buying assets and increasing reserves, and banks are again continuing to hold these reserves instead of putting them into circulation. Since the Fed’s goal is 2% inflation, meeting this goal requires increasing the money supply at a rate that is 2% points faster than the rate of growth of real GDP.
To achieve the money supply growth to keep the economy moving, or even to get close to the Fed’s target inflation rate, will require a significant increase in the difference between the IOER and market opportunities for banks. Returning to the market interest advantage for banks suggests that the IOER should be set to give a market advantage of 40 basis points for the 10s, 20 basis points for the 1 years and a 5 basis point advantage for the 3 month treasury rates. To achieve that will require at least a 20 basis point reduction in the IOER from its current 1.55% to 1.35%.