Has the Fed lost control of interest rates?

Q. Long Term interest rates have shot up recently. Has the Fed lost control of interest rates?

A. The Fed never did have control over long term interest rates.  They can directly control the fed funds rate; and they do have influence over the longer end of the curve, but the bond market is too big to maintain direct control over. There are various ways of measuring the size of the bond market. Most would agree that all bonds including mortgage backed securities plus corporate and miscellaneous government debt instruments amounts to about 37 trillion dollars. The trading volume in the bond market is over 800 billion dollars per day. Obviously 85 billion in purchases by the Fed, spread over a period of a month (2.8 billion a day) is a token amount in this huge market and can hardly move the market as a whole.

It has been claimed that the Fed is purchasing most of the new issuance of new government debt, but this is simply wrong. The Fed is prevented by law from purchasing new debt in the primary market. They can only purchase it in the secondary market.

The primary market is where new debt is issued and bought, and if you look at just that market and calculate it against the 85 billion of Fed purchases per month, then yes you can say that as a percentage of new debt being issued, the Fed is buying an equivalent amount. But in fact they are not buying any of it. It is a mathematical and theoretical number only, and as such, a fiction.

Such small amounts of purchases in the secondary market can scarcely move interest rates. However, the purchase of mortgage backed securities is far more affective in influencing mortgage rates since the MBS market is so much smaller than the treasury market. But even so, mortgage rates have still moved up in the face of the Fed buying some 40 Billion in mortgage backed securities a month.

The Fed only controls the overnight fed funds rate which banks lend to each other. At any time and for any number of reasons long term interest rates can move higher and there is nothing the Fed can do to stop them. They tried very hard in the late seventies and watched them soar to over 20% in a matter of months and there was nothing they could do to stop them then – and there is nothing they can do to prevent them from going higher now if the market wants to take them higher. The market is in control, not the Fed.

We may be at the beginning of a substantial move in interest rates in the future as the 10 year note just moved from 1.6% to 2.7%. This is one of the fastest and largest moves upward we’ve seen in long rates in decades. The market may be trying to tell us that real concern over the rising national debt and a turn away from disinflation to reflation may be at hand. We will know in the fullness of time.

via Concerning Inflation, Deflation, and Rising Interest Rates – PaulNathan.biz.

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