In a credit-based economy that revolves around lending and borrowing, interest rates are a hugely important component of the overall economic picture. So it’s no wonder that Wall Street and Main Street both pay close attention to the Fed’s interest rates decisions.
The Fed sets the so-called federal funds rate — the interest rate that banks charge each other for loans — which makes it sound like the Fed is in charge. Certainly, almost every financial pundit out there talks about the Fed and interest rates in those terms.
But the fact is that the Fed is no more in charge of interest rates than it is of the weather.
It may sound shocking, but usually the Fed simply follows the bond market. Bond yields change daily, and central banks don’t control them: Yields (and prices) are set by the bond market. And if you observe the timing of the central bank’s interest rates decisions, you will notice that usually, it doesn’t lead the bond market — it only reacts to what bond yields dictate.
The Fed is not alone in following bond yields. We’ve made similar observations before about the European Central Bank and Reserve Bank of Australia.
To raise or lower interest rates is the single most important tool by which the central bank’s “potent directors” are said to control our economic future. They carefully watch economic indicators, and deftly adjust interest rates accordingly — or so goes the mainstream thinking.
But now that you know that the Fed is not nearly as “in charge’ as it appears, is it a surprise it’s been powerless to revive the economy?