Tuesday, August 14, 2007

The Fed's Undeserved and Unnecessary Attention

A lot of attention is paid to the Federal Reserve's monetary policy, especially its ability to frequently change its target for short-term (overnight) rates, the "Federal Funds Rate."

As the chart above shows (click to enlarge), the target rate for the Fed Funds has ranged from a high of 6% in early 2001, to a low of 1% in 2003-2004, and now back up to 5.25% since July 2006. But notice how relatively stable both the 30-year mortgage rate and the 10-year T-Note rates have been, fluctuating in range of only about +/- 1% while the Fed Funds has fluctuated in a range of +/- 5%. Notice also how the Fed Funds rate has been above the 10-year T-note rate in 2001 and for the last year and a half, and below the 10-year bond rate by 3% in 2003-2004, with almost no effect on the 10-year bond rate in either case.

Bottom Line:
1) The Fed has very little control over long-term interest rates at horizons of 10 years or more, unless expectations of future inflation change significantly, which they apparently haven't.

2) Long-term investment decisions are made based largely on long-term rates (10 years or longer), not short-term overnight rates (Fed Funds).

3) The Federal Reserve's influence on the economy is probably significantly overstated, since it only moves overnight rates around without changing long-term rates.

4) Undeserved attention paid to the Fed injects unnecessary uncertainty into the economy, as Wall Street and Main Street engage in excessive "Fed watching."

5) We'd probably be better off with an inflation target, like Canada, New Zealand, Australia, European Union and the U.K.


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