We at Acropolis spend a lot of time writing about what is going on inside the Federal Open Market Committee (the FOMC is the group within the Federal Reserve in charge of setting monetary policy for the central bank). Considering the amount of attention given to the FOMC in the media and investment industry, one might think the impact of the committee on financial markets is enormous. The committee meets 8 times a year and their statements are regularly the tastiest fodder for market commentary, financial news coverage and best of all… newsletter writing.
But an alternate view is out there. The view that the Fed’s influence is overblown. A view spearheaded by research from Nobel Prize winning economist Eugene Fama, aka the “father of modern finance”. Better known from his pioneering work on the Efficient Market Hypothesis and the Three-Factor Model, his more recent research has been focused on the relationship between the Fed’s stated target for the federal funds rate and other interest rates like 6-month treasury bills, corporate bonds and mortgage rates.
I will leave the data tables and regression data for your own personal scrutiny if you care, (link to article). Instead I will highlight the conclusion he reaches when asking the question, “To what extent does the target for fed funds influence other rates?” Fama attempts to answer this question by testing whether other factors may have an impact on interest rates. He also broadens the scope of what he measures by looking at whether the Fed has an impact on some interest rates more than others.
His main finding is that both short-term and long-term market rates take “large sustained swings” away from the target rate for fed funds, but there is some evidence that the Fed’s target for fed funds has some influence on short-term rates. He finds many cases where market rates lead and the Fed’s target follows, which he claims could either signal a Fed that has no real control or a market that sees the Fed as a predictable and powerful force – changing prices ahead of anticipated changes to the target rate. But there are also many cases when the target for fed funds changes unexpectedly, and market rates quickly adjust to the new target rate. In summary, evidence that the Fed controls short-term rates is inconclusive.
When the study goes further, and begins to test for the Fed’s impact on longer-term rates he finds that the impact really falls off beyond maturities longer than a few months – claiming that factors such as term premiums have much more impact. This makes logical sense. An investor deciding whether a ten-year Treasury bond is a good value, is better served thinking of implications beyond a very short-term policy rate, such as expected inflation, economic growth rates or the opportunity cost of locking money up in such a way.
The final part of the conclusion that covers the period following the 2008 financial crisis is probably the most controversial of them all. His case is that Quantitative Easing is a zero sum game. The process of the Fed purchasing long-term debt in the open market, and in turn taking the cash back in the form of excess reserves (for which they are paying an above market rate) is equated to a leveraged bond transaction. Put another way, the Fed borrows short-term funds to buy long-term bonds. Because the activity is effectively flooding the market with short-term debt, if the Fed had influence on the market, short-term rates should have gone up. Since short-term rates remained near zero for the entire period the Fed was pursuing QE, he claims that market forces beyond the Fed itself are doing the majority of the work when it comes to influencing market rates.
Perhaps a conclusion like this isn’t surprising coming from the office of the world’s most vocal champion of the Efficient Market Hypothesis, but it’s interesting nonetheless. I think there are some limitations to trying to answer this question with statistical data alone. Mostly because the data doesn’t go back very far and even if it did I think a fair amount of qualitative evaluation will always be involved in things like this. With that said, the research looked for evidence in the data that the Fed has control and it wasn’t found. Maybe something to ponder next time the world stops everything to listen to the Fed.