Treasury Auctions Show That the Fed Does Not Control Market Rates

Norbert Michel and Jai Kedia

As the war with Iran draws on, the Trump administration’s hopes for lower interest rates seem to be fading fast. If history is any guide, the administration will probably blame Jerome Powell for failing to produce lower rates, but blaming Powell (or his colleagues at the Fed) makes little sense.

As we’ve pointed out multiple times, that’s just not the way “interest rates” work.

Believe it or not, the folks at the Fed don’t control everything, and they can’t make interest rates whatever they want them to be. The Fed can influence rates, but even that influence wanes the further the investment product deviates from interbank lending in type or duration. Yet, virtually every news cycle suggests that the Fed “sets interest rates,” even though that’s an oversimplification. A huge one. 

The latest example is the “terrible twos.” That is, the surprisingly weak demand during Tuesday’s two-year US Treasury note auction pushed 2‑year rates up to 3.9 percent, the highest they’ve been since July. At roughly the same time, the yield on the 10-year note also rose, as did the 30-year fixed-rate mortgage average. (It appears that investors are worried about inflation creeping higher due to the war with Iran.)

All these rates rose even though the Fed didn’t make any policy moves. (For two consecutive meetings, the Fed held rates steady, a pattern that followed three consecutive cuts.) As difficult as it may be to believe, rates could continue to rise (or fall) even if the Fed does nothing.

Journalists who cover the Fed are surely right to worry about the Fed’s ability to “see through” supply shocks. The problem, of course, is that if inflation increases due to a negative oil shock, the Fed raising its target rate—the normal response to higher inflation—won’t be effective. We’d still have less oil, higher oil prices, and (possibly) tighter credit conditions. 

And while this important distinction is often overlooked, monetary policy can only be effective when the Fed is able to make credit conditions tighter (or looser) than they would be otherwise. That is, if interest rates climb and the Fed raises its target rate to catch up, the Fed won’t be making credit conditions tighter. Markets would have already done that.

This overlooked distinction matters because the conventional story misses the underlying sequence of events and, therefore, suggests a policy that is rather harmful. For instance, one report states: 

If inflation expectations become unmoored, it will make it harder for Federal Reserve officials to look through the transitory effects of an oil shock—which means they might raise interest rates. 

But this (conventional) story ignores the fact that interest rates would have already gone up, and the Fed would be playing catch-up. Put differently, the market would already have pushed interest rates to a higher equilibrium, and the Fed would have no choice but to raise its official target rate. It will be equally as hard for monetary policy to be effective in the face of these supply shocks, but it won’t be any harder for the Fed to “see through” those supply shocks. 

This explanation also shows why Congress should not view monetary policy as the Fed “setting interest rates.” If the Fed does anything other than move its target rate to “catch up” with movements in the market, then monetary policy is properly viewed as the Fed trying to push lending rates in the opposite direction that market forces have suggested they should go. 

Viewed through this lens, it makes even less sense for Congress to allow the Fed to set its target based on subjective readings of the economy without quantifying exactly how and why it arrived at its target. It is virtually impossible to hold the Fed accountable for the effects of monetary policy while it operates with such wide discretion, yet this is exactly how Congress allows the Fed to operate. 

The truth is that monetary policy works better when it is less discretionary and more objective. Had the Fed been following a rule after the pandemic, for instance, it is likely that its rate targets would match market conditions much better rather than become a source of dissonance itself. But such reform is unlikely while people view the Fed as an all-powerful institution that predicts economic ebbs and flows better than markets do, one that can dial in precise values for interest rates or inflation. 

The Fed should be viewed as an error-prone entity that faces the same informational burdens as any other government agency. As such, Congress should place guardrails on its powers and ensure its policymaking is accountable and transparent.