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It can be a bit hard to picture why a number as tiny as, say, 3% is so radically different from 2.5%, and why so much fuss is made about them.

Put another way, why should you even care about these percentages? What do they mean for you?

Let’s back up for a moment…

The Federal Reserve Bank of the U.S. (the Fed) has two directives from Congress, called the dual mandate. The mandate requires the Fed to provide maximum employment and to provide price stability. They try to meet those objectives by tinkering with interest rate or monetary policy.

The Fed’s most publicized tool for this sort of thing is what’s called the “federal funds rate,” which is the overnight lending rate charged to member banks to meet reserve requirements. A change in the fed funds rate can impact other interest rates but, the market ultimately prices in risk and its outlook of the economy.

Just a couple tenths of a percentage point can very well determine if, say, a company can borrow money from the bank cheaply enough to make a major merger, or avoid layoffs, or finance a risky product change. These rates (and the threat of higher or lower rates) are priced into the market.

Think of the U.S. economy as a pond…

When you’re dealing with billions – if not trillions – of dollars, a few measly percentage points can make a huge ripple in the economy. So, current interest rates and future interest rate changes are really important for companies, consumers and investors alike.

Does the Fed really set interest rates? Well, yes and no.

Since 2008, the Fed dropped the federal funds rate to 0.0% and that’s where that rate sat until December of 2015 when they raised that rate by 0.25%. They once again hiked last December to 0.50%.

The Fed only has control over the very short-term (federal funds) rate as mentioned earlier, but they expect their policy to affect interest rates all the way out to the 30-year Treasury rate.

What the Fed can’t control is the yield curve – or, the spread between the short-term rates and long-term interest rates. When the market believes there’s a lot of risk for inflation and the economy growing too fast, the long-term rates will rise faster and the curve will steepen. When the opposite is believed, the curve will flatten and the spread will narrow.

The Fed doesn’t control the yield curve; the market does.

But the Fed tries to manage the market, however ham-fistedly.

Who wins in the end?

Well, when the market believes the Fed should hike, the market will hike for them by selling off Treasury bonds and raising the yield. That in turn affects mortgage rates, corporate bond rates, municipal bond rates and even car loan rates.

When the Fed loses credibility, the market takes control over the yield curve and we don’t see big reactions following every news item concerning the Fed (including just a couple of quotes in an article in the finance section of your local paper). “Fed-speak” – which is their own version of vague, technical jargon – is a valuable tool of the Fed, but as we’ve seen over the last several years, when there’s a lot of talk and no action, the tool is rendered meaningless.

The Fed’s proposed transparency – by way of their forecasts of inflation, economic growth, and jobs and wage growth – has fallen short, as have its predicted interest rate hikes. When Fed officials have spoken with the intention of leading the market to believe something, they expect the market to react like it’s going to happen.

But when the Feds forecasts are out of line with reality and they speak of possible action without any, the market stops believing. When the market doesn’t believe the Fed, the market sets bond prices and interest rates, not the Fed.

For now, the markets are looking at the incoming economic data and making price adjustments.

The Fed is looking at incoming data and hoping its forecast is in line with its policies. If not, the Fed will adjust its policies and its forecasts.

Don’t fight the Fed by trading against its forecasts, but you certainly don’t need to wait on the Fed to see where interest rates are going or believe what the Fed is trying to feed you.

The markets adjust very quickly and sometimes violently when the unexpected happens, so turn to Economy and Market’s for the most up to date news on the Fed’s next move.

stephen moore

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