Is It Really the Fed?

The constant focus on the Fed is misleading.  The broad course of interest rates are not determined by the Fed, but instead by supply and demand.  The Fed controls only its own lending rate.  It can supplement that control with open markets purchases and sales, but, even there, the power of the Fed is limited.  By purchasing government debt, the Fed is simply printing money digitally, a process which could either raise or lower medium term to long term rates.

Constantly increasing money growth through open market purchases in the 1970s actually raised rates -- to record post-war levels, while economic growth stagnated.  Thus was born the term "stagflation."

One very clear piece of evidence that the Fed does not move rates -- at least the rates that matter -- is the lack of correlation between the Fed's lending rate (which is a repo rate, not, as popularly believed, the federal funds rate) and the two year, ten year and thirty year treasury rates.

The Fed is a follower, not a leader, in the rate business, as was often noted by Paul Volcker, probably the greatest Fed Chairman in history.  Where the Fed can get in trouble is expanding its balance sheet.  The Fed is in serious trouble now, because of an over-bloated balance sheet.

So why all the focus on the Fed?  It is always easier to believe the wizard behind the screen is determining everything and the wizard is relatively easy to keep tabs on.  Hard analysis forecasting future supply and demand is a much harder endeavor and not subject to simple sound bites.

The Fed's balance sheet tells you all you need to know.  If the economy ever shows any real sign of life -- not simply life propped up by the tech and energy sectors -- then dramatic increases in the price level will push rates far higher than the bureaucrats occupying seats at the Fed ever anticipated.

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