Expanding this assessment to the interest rates that consumers face, and in particular mortgage rates at which they borrow and fixed deposit rates at which they can invest, the results are just as stark.

In the quarter after the Fed Funds rate increase, mortgage rates and fixed deposit rates are more likely to fall than rise, with the median change in the 15-year mortgage rate being -0.13% and the median change in the fixed deposit rate at -0.05%. In the quarter after the Fed Funds rate decreases, the mortgage rate does drop, but by less than it did during the Fed rate raising quarters. In short, those of us expecting our mortgage rates to decline in the next few months, just because the Fed lowered rates on Wednesday, are being set up for disappointment. If you are wondering why I did not check to see what credit card interest rates do in response to Fed Funds rate changes, even a casual perusal of those rates suggests that they are unmoored from any market numbers.

    You may still be skeptical about my argument that the Fed is more follower than leader, when it comes to interest rates. After all, you may say, how else can you explain why interest rates remained low for the last decades, other than the Fed? The answer is recognizing that market-set rates ultimately are composed of two elements: an expected inflation rate and an expected real interest rate, reflecting real economic growth. In the graph below, which I have used multiple times in prior posts, I compute an intrinsic risk free rate by just adding inflation rate and real GDP growth each year:

Interest rates were low in the last decade primarily because inflation stayed low (the lowest inflation decade in a century) and real growth was anemic. Interest rates rose in 2022, because inflation made a come back, and the Fed scrambled to catch up to markets, and most interesting, interest are down this year, because inflation is down and real growth has dropped. As you can see, in September 2024, the intrinsic riskfree rate is still higher than the 10-year treasury bond rate, suggesting that there will be no precipitous drop in interest rates in the coming months.

Response to comments: Some readers are suggesting a plausible, albeit convoluted, rationale for this result that preserves the Fed Delusion. In a version of 4D chess, they argue that investors in bond markets are largely in the business of forecasting what the Fed will do and that market rates move ahead of Fed actions. Besides being extraordinarily unhealthy for bond investing, if this is in fact what it is happening, there are four problems with this reasoning, First, bond markets pre-date central banks setting rates, and they seemed to do a reasonably good job before the Fed Funds rate was around. In fact, I started in investing in the 1980s, when the Fed went into hibernation on the Fed Funds rate, and trust me when I say the bond market did not miss a beat. Second, if the entire point of bond investing is forecasting what the Fed will do, how would you explain the rise in treasury bill and bond rates in the first half of 2024 (just to give one instance), when all the talk was about the Fed cutting rates, not raising them? Third, if bond markets exist to bet on Fed movements, when the Fed moves unexpectedly (by raising or lowering rates more than expected), there should be an immediate adjustment in the bond market? Thus, last week, when the consensus was that a 25 basis point cut was more likely than a 50 basis point one, there should be have a significant drop in treasury rates in the days after, and there was not. 

The Fed as Signalman

    If you are willing to accept that the Fed does not set rates, and that it does not lead the market on interest rates, you may still argue that Fed rate changes convey information to markets, leading them to reprice bonds and stocks. That argument is built on the fact that the Fed has access to data about the economy that the rest of us don’t have, and that its actions tell you implicitly what it is seeing in that data. 

    It is undeniable that the Federal Reserve, with its twelve regional districts acting as outposts, collects information about the economy that become an input into its decision making. Thus, the argument that Fed actions send signals to the markets has basis, but signaling arguments come with a caveat, which is that the signals can be tough to gauge. In particular, there are two major macroeconomic dimensions on which the Fed collects data, with the first being real economic growth (how robust it is, and whether there are changes happening) and inflation (how high it is and whether it too is changing). The Fed’s major signaling device remains the changes in the Fed Funds rate, and it is worth pondering what the signal the Fed is sending when it raises or lowers the Fed Funds rate. On the inflation front, an increase or decrease in the Fed Funds rate can be viewed as a signal that the Fed sees inflationary pressures picking up, with an increase, or declining, with a decrease. On the economic growth front, an increase or decrease in the Fed Funds rate, can be viewed as a signal that the Fed sees the economy growing too fast, with an increase, or slowing down too much, with a decrease. These signals get amplified with the size of the cut, with larger cuts representing bigger signals.

    Viewed through this mix, you can see that there are two contrary reads of the Fed Funds rate cut of 50 basis points on Wednesdays. If you are an optimist, you could take the action to mean that the Fed is finally convinced that inflation has been vanquished, and that lower inflation is here to stay. If you are a pessimist, the fact that it was a fifty basis point decrease, rather than the expected twenty five basis points, can be construed as a sign that the Fed is seeing more worrying signs of an economic slowdown than have shown up in the public data on employment and growth. There is of course the cynical third perspective, which is that the Fed rate cut has little to do with inflation and real growth, and more to do with an election that is less than fifty days away. In sum, signaling stories are alluring, and you will hear them in the coming days, from all sides of the spectrum (optimists, pessimists and cynics), but the truth lies in  the middle, where this rate cut is good news, bad news and no news at the same time, albeit to different groups.

Response to comments: Fed rate change signals, as I mentioned, are tough to read. If you have strong priors on the Fed having power to drive markets, you can always the benefit of hindsight to bend the signal to match your priors. 

The Fed as Equity Market Whisperer

    It is entirely possible that you are with me so far, in my arguments that the Fed’s capacity to influence the interest rates that matter is limited, but you may still hold on to the belief that the Fed’s actions have consequences for stock returns. In fact, Wall Street has its share of investing mantras, including “Don’t fight the Fed”, where the implicit argument is that the direction of the stock market can be altered by Fed actions. 

    There is some basis for this argument, and especially during market crises, where timely actions by the Fed may alter market mood and momentum. During the COVID crisis, I complimented the Fed for playing its cards right, especially so towards the end of March 2020, when markets were melting down, and argued that one reason that market came back as quickly as they did was because of the Fed. That said, it was not so much the 100 basis point drop in the Fed Funds rate that turned the tide, but the accompanying message that the Federal Reserve would become a backstop for lenders to companies that were rocked by the COVID shutdown, and were teetering on the edge. While the Fed did not have to commit much in capital to back up this pledge, that decision seemed to provide enough reassurance to lenders and prevent a host of bankruptcies at the time.

    If you remove the Fed’s role in crisis, and focus on the effects of just its actions on the Fed Funds rate, the effect of the Fed on equity market becomes murkier. I extended the analysis that I did with interest rates to stocks, and looked at the change in the S&P 500 in the quarter after Fed Funds rates were increased, decreased or left unchanged:

The S&P 500 did slightly better in quarters after the Fed Funds rate decreased than when the rate increased, but reserved its best performance for quarters after those where there was no change in the Fed Funds rate. At the risk of disagreeing with much of conventional wisdom, is it possible that the less activity there is on the part of the Fed, the better stocks do? I think so, and stock markets will be better served with fewer interviews and speeches from members of the FOMC and less political grandstanding (from senators, congresspeople and presidential candidates) on what the Federal Reserve should or should not do.

Response to comments: Here again, the 4D chess argument comes out, where equity markets are so clever and forward-looking, they already incorporate what the Fed will do. Without realizing it, you are making my case that when discussing equity markets and where they will go in the future, we should spend less time talking about what the Fed will do, might do or has not done, since if your premise about markets as forecasting machines is right, it is already in prices.

The Fed as Chanticleer

    If the Fed does not set rates, is not a interest rate driver, sends out murky signals about the economy and has little effect on how stocks move, you are probably wondering why we have central banks in the first place. To answer, I am going to digress, and repeat an ancient story about Chanticleer, a rooster that was anointed the ruler of the farmyard that he lived in, because the other barnyard animals believed that it was his crowing every morning that caused the sun to rise, and that without him, they would be destined for a lifetime of darkness. That belief came from the undeniable fact that every morning, Chanticleer’s crowing coincided with sun rise and daylight. The story now takes a dark turn, when one day, Chanticleer sleeps in and the sun rises anyway, revealing his absence of power, and he loses his place at the top of the barnyard hierarchy. 

    The Fed (and every other central bank) in my view is like Chanticleer, with investors endowing it with powers to set interest rates and drive stock prices, since the Fed’s actions and market movements seem synchronized. As with Chanticleer, the truth is that the Fed is acting in response to changes in markets rather than driving those actions, and it is thus more follower than leader. That said, there is the very real possibility that the Fed may start to believe its own hype, and that hubristic central bankers may decide that they set rates and drive stock markets, rather than the other way around. That would be disastrous, since the power of the Fed comes from the perception that it has power, and an over reach can lay bare the truth. 

Response to comments: My comments about the Fed being Chanticleer have been misread by some to imply that central banks do not matter, and Turkey (the country, not the Thanksgiving bird) seems to constantly come up constantly as an example of why central banks matter. Again, you are making my case for me. There is nothing more dangerous to an economy than a central bank that thinks it has the power to override fundamentals and impose its preferred interest rates in the economy. The Turkish central bank, perhaps driven by politics, seems to think that the solution to high interest rates (which are being driven by inflation) is to lower the rates that it controls. Not surprisingly, those actions increase expected inflation, and drive rates higher…. (see definition of insanity..)

Conclusion

    I know that this post cuts against the grain, since the notion that the Fed has superpowers has only become stronger over the last two decades. Pushed to explain why interest rates were at historic lows for much of the last decade, the response you often heard was “the Fed did it”. Active investors, when asked why active investing had its worst decade in history, losing out to index funds and to passive investors, pointed fingers at the Fed. Market timers, who had built their reputations around using metrics like the Shiller PE, defended their failure to call market moves in the last fifteen years, by pointing to the Fed. Economists who argued that inverted yield curves were a surefire predictor of recessions blamed the Fed for the absence of a recession, after years of two years plus of the phenomena. 

    I believe that it is time for us to put the Fed delusion to rest. It has distracted us from talking about things that truly matter, which include growing government debt, inflation, growth and how globalization may be feeding into risk, and allowed us to believe that central bankers have the power to rescue us from whatever mistakes we may be making. I am a realist, though, and I am afraid that the Fed Delusion has destroyed enough investing brain cells, that those who holding on to the delusion cannot let go. I am already hearing talk among this group about what the FOMC may or may not do at its next meeting (and the meeting after that), and what this may mean for markets, restarting the Fed Watch. The insanity of it all! 

YouTube Video

Data

1. Fed Funds Rates, Treasury Rates and Other Market Interest rates – Historical
2. Intrinsic treasury bond rates