Is the Fed Taking Note of Market Volatility?

The Federal Reserve (Fed) only controls one rate of interest, and it is a very short-term rate called the federal funds rate, the rate that banks charge each other for overnight, intra-bank loans. The rest of the rates, i.e., longer-term rates, are determined by the markets. Thus, when the Fed increases the federal funds rate, it does that by selling bonds into the market and thus ‘drying’ the market of liquidity. This reverberates in the market for loanable funds, pushing longer-term interest rates higher across all of the maturities.

It is a very inefficient way of doing things, but it is the only way it has to influence market interest rates, and more times than not, the market reaction to a higher federal funds rate does not translate into precisely what Fed officials are expecting in terms of longer-term interest rates. So, when that is not enough, they use another, less ‘scientific’ instrument, something they call ‘guidance’. Sometimes this ‘guidance’ is not effective, and markets disregard it. However, since the September Federal Open Market Committee (FOMC) meeting, something ticked with markets and the ‘guidance’ Fed officials had been giving for many, many months, finally caught the market’s attention. That is, after the FOMC meeting in September, markets finally took their ‘guidance’ to heart: “higher interest rates for longer.”

Since then, the yield on the 10-year Treasury has skyrocketed and hit a high of 4.85% today. Now, of course, many have come out predicting that the yield on the 10-year Treasury will hit 5%, which would have been a risky call several months ago, but not today.

US 10 Year Treasury Yield

This surge in long-term yields is going to put further upward pressure on mortgage rates and is probably going to weaken the housing market again, with the caveat that the still very low inventory of homes could keep new home sales going stronger than what otherwise would have been the case given such high mortgage rates.

Thus, if monetary policy decisions were difficult up until now, they have become even more difficult today. That is, before September of 2023, Fed officials had been increasing interest rates and giving ‘guidance’ to the markets so longer-term interest rate would increase to the Fed’s desired level, a level that was enough to constrain economic growth. So far, higher interest rates have done little to slow down economic activity, but it is difficult to know if the reason for this is that interest rates are not high enough or if the normal lag with which monetary policy works is such that the Fed has to wait until those increases in interest rates affect economic activity.