If You Think The Fed’s Rate Is Scarily High, You Won’t Want To See This One

If You Think The Fed’s Rate Is Scarily High, You Won’t Want To See This One
Stéphane Renevier, CFA

29 days ago2 mins

When it comes right down to it, the Federal Reserve (the Fed) has three gizmos in its toolbox that it can use to heat things up or cool things down, as needed. Its most important gadget is the fed funds rate (blue line) – that’s the interest rate banks charge each other for quick loans. But it’s also got a tool that allows it to pump more money into the banking system by buying securities like bonds (think: quantitative easing), and it’s got its own special loudspeaker, which allows it to influence lending, borrowing and market activity by dropping hints about its next play (that’s "forward guidance"). So, while the fed funds rate can tell you something about the temperature of the money scene, there’s always more to the story.

To provide a better estimate of what the Fed’s been up to (i.e. its monetary policy stance), some researchers crafted a model that eyes 12 financial markers, from Treasury rates to mortgage rates to added borrowing fees. This “proxy rate” (green) doesn’t track the fed funds rate alone – it also keeps tabs on the Fed’s other devices.

The difference between the two is interesting: from 2010 to 2016 while the fed funds rate was a flat zero, the proxy rate was even lower, because the Fed was juicing the economy with other tricks. Lately, though, it’s flipped. And with the proxy rate at a lofty 7% versus the fed funds rate’s 5.3%, it’s clear that monetary policy’s been pulling the system’s reins tighter, and faster, than it otherwise might seem.

That means borrowing money might be even harder for people and companies than what the already sky-high fed funds rate would suggest. And, look, we know that economies tend to react to changes in monetary conditions with a delay, so we might soon be surprised by a jolt from these sharply higher rates. But there may be a silver lining: if the Fed’s been grinding harder than that rising rate lets on, it might already be further along in its battle against inflation. And that might mean a real end to all those interest rate hikes and, potentially, a rate cut on the horizon. All in all, the road ahead is murkier than it might seem, so be ready for a few financial twists and turns.



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