How does the Fed decide monetary policy and why does it come with a time lag?

July 22, 20225 min read
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In the headlines: The Federal Reserve raised its target interest rate by three-quarters of a percentage point in June, in an aggressive effort to cool down inflation. 

After June’s CPI report, which beat expectations, futures contracts related to the Fed’s overnight rate briefly traded up to 90 basis points on July 18, signaling that investors are wagering high interest rate increases in July. Expectations have since tamed and investors are now overwhelmingly rallying behind a 75 basis point-rate increase. 

This is all happening in the context of commodity prices and core inflation both falling, potentially indicating that inflation is peaking (by some accounts, it’s already peaked). In June, employers added 372,000 jobs, and the unemployment rate is currently at only 3.6%, relatively low and not indicative of a recession. But stagflation – a period characterized by soaring inflation and rising unemployment –  is a prominent threat

Related but on a different note, yields on two-year Treasuries briefly rose above those of 10-year Treasuries for the third time this year, a phenomenon known as a yield curve inversion – but more on that below.

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Why it matters: Tightening monetary policy is key in taming inflation. 

— But coming up with the target fed funds rate is a game of precision, where the goal is to have the “right” amount of money circulating through the economy at a given period of time. To raise interest rates, the Fed withdraws liquidity from the U.S. financial system, making interbank lending – and consequently, all other forms of short-term lending – more expensive. This can slow demand, but if overdone, it can also trigger a recession. Conversely, lowering rates can help bolster the economy out of a slump, but it’s at the risk of increasing inflation. 

Monetary policy also acts with a delay, because the “interest rate” that the Fed slashes or hikes up is really a benchmark rate, known as the fed fund rate, that then filters out through the rest of the economy by affecting other key rates. The immediate impact is on  the (OBFR) or the overnight bank funding rate –  banks decide on this rate every day when lending to each other, and overtime, gradual changes in the OBFR influences what these institutions charge their customers for loans, which is the level at which the price surge is occurring (Importantly, fed fund rates don’t directly affect mortgage rates –- that’s the 10-year treasury yields rates. But over time mortgage rates also change in response to everything else) The time it takes for the changes implemented on the Fed level to impact the borrowing rates the banks have for auto loans for example, is usually about 6 months. 

On top of that, inflation reports are also backward looking, making the job of figuring out our reference point – or where we even are in the inflationary cycle – equally hard. Faced with these challenges, target rates and monetary policies surrounding them have to be carefully considered and unsurprisingly, incite a fair amount of debate between policymakers, economists and the general public. 

“Historically, interest rate hikes only have their biggest impact on real economic activity after 12-18 months, meaning that the Fed risks raising rates at exactly the wrong time as it continues to fight last year’s war,” writes Matthew Weller, Global Head of Market Research at GAIN Capital.

“I’m confident that the economy will be able to withstand [another interest rate hike]” said the Fed’s Atlanta President Raphael Bostic and threw his weight behind a 75 basis point hike in July.

Between the lines:  If the Fed’s rate hikes are not timed or sized correctly, they can actually hurt the economy. History has some bittersweet takeaways:

— The Carter-Reagan transportation deregulation initiatives – which targeted inflation in the late ‘70s through a series of antitrust laws–  showed that even highly successful microeconomic policies can take a decade or more to affect prices. This time frame might be shorter today, but not immediate.

— The last set of aggressive rate hikes happened in 1981, when the US was in the midst of a second brutal stint of double-digit inflation in less than a decade. At that time the Fed chairman was Paul Volcker, who famously implemented a target that once reached 20% to curb the price surge. The policy was effective by the late 1980s,  but only after the economy went through a recession twice. Similar rate hikes would probably be unlikely today, but it shows that aggressive stances on tightening the economy come at a steep price.

In terms of that two vs 10 year Treasury yield curve that inverted, all that tells is that bonds with shorter maturity periods now have higher yields than longer term bonds. In a normal yield curve, that shouldn’t be the case because naturally, bonds held over a longer period of time are the riskier asset and so should be accompanied with the higher yield. 

— The inversion made headlines because it has predicted some recessions in the past,though not all. The Fed’s preferred “forecaster” curve is actually the three-month compared to the 10-year yield curve, which isn’t close to inverting. 

— Still, the phenomenon may speak to investor sentiment, since shorter term investments can become more attractive in times when confidence in monetary policy is low. But skeptics pointed out that the Fed, and quantitative easing programs from other central banks around the world also buy these bonds, and argued that muddies the yield curve’s ability to gauge economic health. 

For what’s worth, JPMorgan CEO Jamie Dimon released a statement last week saying, “Even if we go into a recession, [consumers are] entering that recession with less leverage, in far better shape than they did in ’08 and ’09, and far better shape than they did even in 2020.

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