Tag: policy interest rate

Econ 101: Interest rates

President Trump wants the Federal Reserve to lower interest rates thinking that that would reduce the interest the Federal Government pays in interest on its debt, which this last year was $1.13 trillion (yes trillion). Prior to 2008, the Fed’s policy interest rate—the so called Fed funds rate—was the overnight rate on overnight (i.e. one day) loans between banks. I will skip how the Fed determines (brings about in the market) that rate. Since 2008, when the Fed started to pay interest on bank reserves (deposits at Federal Reserve Banks), the Fed’s policy rate has been the rate paid on bank reserves.

The interest rates paid on longer (than overnight) loans (e.g., one, two, ten-year bonds) are related to the overnight rate because rolling over overnight loans for ten years is an alternative to a ten-year bond. This note explains that relationship.

The interest rate on, say, a one-year bond reflects what the market (lenders and borrowers) expects the one-day rate to be each day over that period. That, in turn, depends on what the market expects the “real” rate to be plus the rate of inflation. Market rates reflect the real rate plus the inflation rate. If inflation increase, other things equal, market interest rates increase.

So, the interest rate on a ten-year bond will reflect what the market expects the overnight rate to be over the next ten years, which reflects the expected real rate and the expected inflation rate over that period. So what happens to interest rates (say the ten-year bond rate) when the Fed lowers its policy rate as President Trump wants? It depends primarily on what that does to the market’s expectation of inflation over the relevant future period.

On Wednesday Dec 10 the Fed reduced its policy rate .25% to 3.50 to 3.75%. On that day the ten-year bond rate fell from 4.19% the day before to 4.15% but by Friday (two days later) had returned to 4.18% In short the ten year Treasury bond rate is essentially unchanged by the quarter percent drop in the Fed’s policy rate. Why? Because the market expects the drop in the overnight rate to be largely offset by a slight increase in inflation over the next ten years.

If the Fed is correct that lowering its policy rate is appropriate for continuing the reduction of inflation to its 2% target, then the ten-year rate will fall as well. Clearly an excessive cut in the policy rate (one that increases the expected rate of inflation) will increase longer term interest rates rather than lower them. Class dismissed.

Econ 101: Interest Rates –Another Go

A month ago I reviewed the role of the Federal Reserve’s policy interest rate: https://wcoats.blog/2025/07/17/the-feds-policy-interest-rate/   The subject is so important and seemingly misunderstand by many that I am reviewing it again here.

Interest rates balance the supply and demand for financial assets. Households and firms that save some of their incomes demand financial assets. Households and firms that borrow to invest in productive capital or for whatever reason supply those assets (mortgages, bonds, etc.). Rates on longer term assets reflect the expected value of the short-term rates over that period. Thus the interest rate on a ten year bond reflects the expected value of one year bills over the ten year period plus a small risk premium because the string of short term loans are an alternative to the single fixed rate ten year loan.

The policy interest rate of the Federal Reserve is set by the Fed to pursue its objective of stable money (defined by the Fed as 2% inflation) and high employment (the Fed’s dual mandate imposed by Congress).

This note reviews the Fed’s policy rate. Since 2008 the Fed’s policy rate has been the rate it pays banks for the money they keep on deposit with a Federal Reserve Bank (of which there are twelve but that is unimportant for understanding the role of the policy rate), which on Aug 6 amounted to $3,332 billion. This rate is known as the Interest on Reserve Balances (IORB).

If the IORB matches comparable market rates for equally liquid funds (the so-called neutral rate), banks will maintain their existing Fed deposits. If it is set above that level, banks will have a financial incentive to place more money with the Fed, i.e. lend less in the market, thus creating fewer deposits and reducing the money supply. If the IORB is set lower than the neutral rate, banks will draw down their Fed deposits to lend more in the market thus increasing deposits and the money supply.

The IORB is currently (Aug 6) 4.5%, where it has remained since Dec 2024. At this rate broad money (M2=bank demand, time and savings deposits) has grown between 4% and 5% (from a year earlier) over the last three months. Given that inflation remains above the Fed’s target of 2% it would not seem wise to lower the policy rate and increase the rate of monetary growth especially as higher tariffs go into effect.

To repeat from earlier blogs (because it is so important), if markets anticipate higher inflation in the future (next few years), market interest rates on longer term debt will increase to preserve their real (inflation adjusted) value. Lowering the Fed’s policy rate prematurely would increase the market’s anticipation of higher inflation rates in the future. In other word, lowering the IORB now is likely to increase interest rates on longer term debt. Leave the Fed alone to do its job as best it can.