Fed decision-making and market dynamics

The policy variable that reflects the tone of monetary policy most concisely is the target rate for the federal funds rate. The Fed sets this target at each of its Federal Open Market Committee (FOMC) meetings, which are held eight times each year. Raising this target reflects a tightening of monetary policy; lowering it reflects a loosening. But how does this mechanism really work?

Let’s start with the basics: In free markets, prices are the equilibrating mechanisms that serve to align the quantity demanded to the quantity supplied in any goods market. Put another way, if demand exceeds supply at some starting price, prices will rise; and conversely if supply exceeds demand, prices will fall. We should recognize that the speed with which prices adjust will vary from market to market; and we should also realize that price adjustments could overshoot their marks from time to time and then subsequently correct. For actively traded markets like publicly traded securities, price adjustments occur, literally, moment to moment. For more esoteric goods, price adjustments may require substantially more time (e.g., home prices).

An analogous rationing mechanism exists for credit markets – i.e., markets for interest bearing instruments – where interest rates substitute for prices. And while credit markets are somewhat segregated – e.g., the market for 10-year Treasury bonds is distinct from the market for residential mortgages -- supply and demand of any particular credit market will be sensitive to and reactive to changes in the interest rates in other credit markets, as well as their own.

With this foundation, let’s turn attention to the Federal Reserve’s policy of targeting the federal funds rate. The federal funds market facilitates interbank borrowing and lending on an overnight basis. With normal market functioning, this rate will rise when the demand for overnight funds exceeds supply and vice versa. The Fed casts particular attention to this rate by establishing a targeted range for it, with the added instructions that the Fed’s trading desk should buy and sell government and agency securities (primarily) in a manner that is consistent with realizing the stated fed funds target.

When the Fed buys securities in the open market, it puts cash into the pockets of the sellers; and conversely when the Fed sells securities, it takes cash out of the pockets of the buyers. In the first case, we’d have an expansionary (loosening) monetary policy whereby the added liquidity for the public is a lubricant that fosters a marginal boost to consumer spending and business investment (i.e., private spending categories). In the second case we’d have a contractionary (tightening) policy whereby the withdrawing of liquidity would have a marginal effect of dampening spending and investments.

Setting a fed funds rate target can be thought of as reflecting the Fed’s sensibilities as to the pace at which monetary policy should adjust. As a rule, raising the target rate would reflect tightening monetary policy, while lowering the target rate would reflect a loosening. But how much of a change would be “too tight” or “too loose?” That’s where the fed funds rate target comes in. The bigger the change in this target rate, the more aggressive the adjustment of monetary policy. The determination as to how much to change this target, however, is a judgment call, collectively made by the FOMC.

So, what can we look forward to? As of the latest data, it appears that the concerns about inflation and unemployment – i.e., the two areas of concern for the Fed -- are roughly in balance. If this balance were to persist, there would seem to be little justification to change the fed funds target. Nonetheless, a majority of the FOMC members have signaled their expectation that further rate cuts will likely occur over the coming year, suggesting that, at least in their calculus, unemployment will become a bigger concern relative to inflation and a looser policy would be in order.

I wouldn’t count that out, but I wouldn’t bet on it, either. I endorse the Fed’s commitment to have their policy dictated by the upcoming data. Offering projections for future rate cuts, however, unnecessarily complicates that commitment.