By Dr. George Calhoun
Executive Director of the Hanlon Financial Systems Research Center at Stevens Institute of Technology
The Federal Reserve’s most important monetary policy tool is the Fed Funds Interest Rate target. By raising or lowering this benchmark, the Fed hopes to influence the cost of credit throughout the economy, to stimulate or restrain, to control inflation and promote full employment. It is widely assumed that the Fed Funds Rate is an effective lever to move market interest rates, both short-term and long-term rates. For decades, that assumption appeared to hold up.
No longer. This critical policy lever is broken. It stopped working quite suddenly about a year ago. The Fed lowered its target rate three times from September to December 2024, and is getting ready to lower it further – but real interest rates in the market have moved decisively upwards. The correlations between the policy rate and the most important market rates (like Treasury yields and mortgage rates) flipped from extremely positive (i.e, strongly synchronized) prior to September of last year to extremely negative (moving in opposite directions) almost overnight. It is not clear if the breakdown of this long-standing relationship is temporary (“transitory”?) or if it represents a structural shift in the way the macroeconomic system operates. If it is structural, it would mean that the Fed has lost some of its ability to influence the economy. Which could have momentous consequences.
The financial markets are treating the prospect of a rate cut next month as a psychological event. Market sentiment surrounding this prospect is decidedly positive. But viewed as a fundamental economic event, the outlook is cloudy. Last year’s cuts have not worked as a stimulus – have not lowered important market interest rates, and appear in fact to have pushed them higher. Why should a different outcome be expected this time?
The Market Holds Its Breath
As summer comes to an end, the attention of the financial world is locked in on the Federal Reserve, and the possibility of an interest rate cut in September.
Will it happen?
The markets are pretty well convinced. Investors have been positioning for a cut for weeks. “Bets on Fed Rate Cuts Are Sweeping Through US Bond Market” was a Bloomberg headline earlier this month, and that was even before Chairman Powell teased in his Jackson Hole speech that “a shifting balance of risks may warrant adjusting our policy stance” – classic Fedspeak which the markets took as a Yes, and bid up the value of U.S. equities by about a trillion dollars that same day. The President has been leaning hard on Fed Chairman Powell to reduce rates, and the pressure to cut is building within the Fed itself. Two Fed Governors dissented from the no-change consensus at the July Federal Open Market Committee meeting and voted for a cut – the first time since 1993 that two FOMC members have broken ranks on a key policy decision.
Technical metrics and forecasts are flashing green. CME’s FedWatch tool puts the chance of a September rate cut at 87% (up from 60% a month ago). Other financial industry estimates approach near-certainty. Prediction markets are currently showing a 75-80% probability of a 25 bps reduction in the Fed Funds target, and many professional traders are betting on a larger move. Treasury Secretary Scott Bessent has projected the possibility of a 50 bps cut – on a downward path to 150-175 bps lower soon.
So, will it happen? It seems so.
But the more important question is: If or when it does happen, will it actually matter?
Does Interest Rate Policy Still Work?
Let’s go back a year. On September 16, 2024, after a long period of quiescence in interest rate policy, the Federal Reserve finally lowered the Fed Funds Rate target – the first downshift in more than 4 years. It was intended as a stimulus, or an easing of restraint. The normal expectation would have been for market interest rates to move downwards as well, lowering the cost of credit for consumers and businesses to encourage borrowing and spending. Lower rates on treasury bonds would reduce the cost of funding the federal government. Lower mortgage rates would unlock the stalled housing market. Cutting the Fed Funds target is the normal policy tool for this purpose. It has almost always worked before.
Not this time. The rate cut on Sept 16 triggered a rapid and pronounced rise in the yields on Treasury bonds, and a similar steep increase in average mortgage rates. In just 6 weeks, both long-term rates lurched upwards.