The Federal Funds Rate: Back to the Drawing Board

Chief Economist Eugenio J. Alemán discusses current economic conditions.

We have been saying, for many months now, that the more markets try to second guess the Federal Reserve (Fed) and push longer-term interest rates down, the higher would be the probability that the Fed would continue to increase the federal funds rate.

What happened with the release of the Survey of Economic Projections (SEP) was just that. Since the Fed has not been able to convince markets that longer-term interest rates need to be higher – and for longer – the only recourse the Fed has is to increase the only interest rate it controls, the federal funds rate, in order to push longer-term interest rates higher. However, after more than a year and a cumulative 500 basis point increase, markets continue to speculate that the Fed is going to pivot very soon, and this has pushed longer-term interest rates lower, as was the case during the first quarter of the year.

We have covered this topic before. Here is what we wrote on March 3, 2023, in our Thoughts Of The Week: “The question today, and for the last year, has been how high the Fed is going to go. However, what markets seem to not understand is that the answer is in the hands of the market, not the Fed. The more markets try to push long-term interest rates down, the more the Fed will tighten monetary policy, period.”

We further said: “You would probably ask why? Because the Fed has control over only one rate of interest, the federal funds rate. All the other interest rates are determined by market forces. The Fed can try to ‘guide’ the markets to what it wants them to see, but markets are, many times, stubborn, and don’t want to believe what the Fed is trying to convey. This is one of those times.”

Markets should take the new ‘dot plot’ and the SEP as instruments of monetary policy and not discount the information it brings. These instruments are part of what the Fed calls ‘guidance’ and guiding is what it is doing even though it decided to pause during the Federal Open Market Committee meeting.

Survey of Economic Projections