The central bank interest rate – who really sets the interest rate, Jerome Powell or the markets?

by time news

Are market expectations the ones that determine the central bank’s interest rate decision or does the interest rate decision lead to expectations? The answer is not simple. The determination of the interest rate by the American Federal Bank is an event that affects all markets in the world including the Israeli capital market. To a certain extent, the policy of the American Bank dictates the policy of the central banks in the entire world, if only from foreign exchange policy considerations which are affected by the interest rate differentials.

The Federal Open Market Committee (FOMC) meets 9 times a year on fixed dates for two days of discussions, at the end of which the interest rate of the Federal Reserve Bank is determined.

To understand the subject of interest rate determination in depth, two interest rates must be considered. One is the interbank interest rate known as the Federal Fund rate, which expresses liquidity trading between the banks through their account at the central bank, and therefore this interest rate is referred to as FF. This interest rate is a clear indication of a credit crunch, if any, as it is the fastest and cheapest source of liquidity for banks in the short term of a day, two days or a week.

The second interest rate is the Federal Reserve Bank rate set by the FOMC. Quite ironic, but this interest rate, which is supposed to express the interest rate charged by the central bank on its loans to banks, constitutes a marginal percentage of the total credit in the economy, yet its influence is enormous. At the end of 2018, the total credit granted by the central bank was only 250 million dollars (almost zero from the total sources of the banks). In 2009, amid the financial crisis, it jumped to $700 billion. In 2020, the year of the corona virus, it jumped, compared to previous years, to about 100 billion dollars (source: FRED). Although in February of this year the total amount of credit granted by the central bank increased significantly, it still represents a null percentage of sixty percent of the total amount of bank credit.

In other words, the Federal Bank cannot dictate interest rates, since its effect on interbank loans is negligible, but despite this the effect of this interest rate on the capital market is enormous. Since the Federal Bank started raising the central bank interest rate about a year ago, it has continuously raised the interest rate 9 times at a rate of between a quarter and three quarters of a percent each time. His goal was clear: to try to moderate the inflation that reared its head through the mechanism of interest rates.

The question is what causes the Federal Bank to set interest rate increases? Why quarter percent or half percent or any other rate?

The answer to this is interesting: market expectations have considerable weight in the decision. After the Federal Bank’s first decision to raise the interest rate about a year ago, an increase that surprised the market, in every subsequent increase the market embodied the rate of increase long before the decision was made (an embodiment reflected in the FF interest rate and government bond rates). In other words, the consensus in the market Regarding the rate of increase, match the actual decision on the rate of interest rate increase.

Let’s understand the reason for the market’s ability to correctly predict interest rate increases – there has been a fundamental change in the FOMC’s approach in the last fifty years. In the distant past, monetary policy adopted the doctrine of Lux and Friedman that the only way in which monetary policy can have an effect is through the element of surprise.

That is, if the intention of the monetary policy designers is to influence this or that economic variable, they must take steps that the market does not expect. In recent years, the approach has changed from end to end, as the perception today is that the interest rate change can be “remedial” in its effect on inflation and without causing a severe recession; And it happens precisely when the change in the interest rate is expected. Therefore, the central bank’s interest rate decision is influenced quite a bit by the market’s expectations for a change in interest rates prior to the decision.

In conclusion, the process of interest rate changes is based on mutual feeding: on the one hand, market expectations are influenced by the central bank’s intentions, and on the other hand, the central bank’s decision is influenced by the consensus of market expectations.

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