Will The Fed Cut Interest Rates? Does It Matter? Recent History Says No.

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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.

Two more rate cuts followed in November and December, dropping the Fed Funds rate by a total of 100 basis points in three months. The long-term market rates continued to surge upwards, bolting higher with each rate reduction.

The gap between the policy rate and the most important long-term market rates ballooned by more than 2 full percentage points.

The rise in treasury bond yields and mortgage rates leveled off after January, but the gap has not closed.

A Broken Pattern, An Ineffective Policy?

Since 1972, the Fed Funds Rate has been almost perfectly correlated with the 10-year Treasury Bond yield (90.4%) and the 30-year mortgage interest rate (91.6%). That relationship has broken down.

Treasury yields and mortgage rates were inversely correlated with the Fed’s policy rate from September 2024 to to January 2025 – strongly so, at negative 80-90%.

Corporate bond yields followed the same pattern, as did – strangely – German and British government bond yields.

Across all these markets, the shift in direction was decisive – from moving with the Fed prior to the first rate cut, to moving strongly against the Fed afterwards. The reversal of the long-established pattern was abrupt and definitive.

From a policy perspective, thsi means that the Fed has been unable to effect a monetary stimulus by the traditional means. The rate cuts backfired, probably helping to drive up the cost of credit in the economy.

It is true that certain short term rates such as the interest rate on auto loans, rates on personal bank loans, and credit card interest appear to have moved downward with the Fed’s rate cuts. The so-called Prime Rate has move down as well. But it is the long-term rates that apply to the largest credit markets. Treasury bonds, municipal bonds, residential and commercial mortgages, and corporate loans and debt securities – which have all moved against the Fed’s rate cuts – account for about 25 times the amount of interest bearing debt compared to the categories that have moved in sync with the Fed Funds Rate.

The Federal Reserve may be trying to drive a car with a gas pedal that doesn’t work.

Alan Greenspan’s Conundrum – ‘Broadly unanticipated behavior’

This has happened before. In February 2005, in the course of Congressional testimony then-Fed Chairman Alan Greenspan mused about a “conundrum” in the bond market. The Fed had raised the Fed Funds target rate by 150 basis points between June 29, 2004 and February 2, 2005 – but the yields in the Treasury market did not rise – which was the Fed’s policy goal. Instead they fell by 70 bps, contrary to the long-established pattern and to the Fed Chairman’s expectations.

“This development contrasts with most experience, which suggests that…increasing short-term interest rates are normally accompanied by a rise in longer-term yields. Historically, even…distant forward rates have tended to rise in association with monetary policy tightening. For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.” – Greenspan’s testimony to Congress (February 16, 2005)

It got worse. Over the next two and a half years the Federal Reserve raised the Fed Funds target rate by a whopping 425 basis points – and the 10 year Treasury yields ended about 5% lower than when the rate increases began.

The phenomenon spurred a fairly large “conundrum literature” over the following dozen or so years — and a surfeit of alternative explanations with no clear winner. It wasn’t just academic economists who were flummoxed. Bill Gross, then-head of Pimco and a true bond market expert, was just as puzzled.

“Who would have thought that the bond market could have [done this]? Not yours truly, nor Alan Greenspan. . . . How then to explain it? . . . I must tell you that we at PIMCO have been talking about this topic for months. We, too, have been befuddled.”

Further Doubts

Today’s anomaly is if anything even more of a departure from the norm than the 2004-2005 episode. Greenspan’s “conundrum” involved a non-response by the market to Fed policy. The divergence of important market rates from Fed policy rates in the last 11 months constitutes a strong contrary response.

Does the Fed’s Interest Rate policy lever really work?

Two large doubts loom over this question.

1. Why Should Short-Term Rate Adjustments Affect the Long-Term Rates Anyway?

The Fed Funds Rate is a target, intended to guide the cost at which member banks lend reserves to one another overnight. It addresses the very shortest of short-term rates – less than 24 hours. It pertains to a limited and peculiar form of credit. The interbank lending to which it applies is not connected to any “investment” or other ordinary business purposes in the larger economy, at least not directly. It is a process of technical calibration, designed to allow banks to stay in compliance with reserve requirements and manage liquidity – essentially to keep their cash balance in good order for purposes of regulatory conformance and general prudence.

There has always been something slightly preposterous about the idea that these ultra-short-term interest rates, which apply to such functionally narrow transactions between huge banks taking place deep inside the Federal Reserve system, could somehow decisively influence the interest rates on, say, 30-year mortgages prevailing out in the vast consumer housing market. And aside from the timing disparity between “overnight” adjustments and loans lasting decades, there is also a disparity in scale. The average daily volume of overnight bank funding is about $200-250 Billion. The combined long-term credit markets described above total more than $70 Trillion. Can such a tiny tail wag such a gigantic dog?

Academic studies of “transmission mechanisms” between short-term policy rate changes and long-term market rate responses have tried to make sense of this policy proposition, but in the end they present a complex and less-than-coherent picture. One study published by the Kansas City Federal Reserve put it this way:

“It is generally believed that monetary policy actions are transmitted to the economy through their effect on market interest rates. According to this standard view, a restrictive monetary policy by the Federal Reserve pushes up both short-term and long-term interest rates, leading to less spending by interest-sensitive sectors of the economy such as housing, consumer durable goods, and business fixed investment. Conversely, an easier policy results in lower interest rates that stimulate economic activity. Unfortunately, this description of the monetary policy process is difficult to reconcile with the actual behavior of interest rates. Although casual observation suggests a close connection between Federal Reserve actions and short-term interest rates, the relationship between policy and long-term interest rates appears much looser and more variable. In addition, empirical studies that attempt to measure the impact of policy actions on long term rates generally find only a weak relationship.”

2. The Impact of Quantitative Tightening?

There is another confounding factor that may offset the stimulus effect of interest rate cuts altogether. In April 2022, after at least four rounds of massive bond buying in the previous 12 years (so-called “quantitative easing”), the Fed’s balance sheet peaked at almost $9 Trillion, and then began to decline as the Fed allowed maturing bonds to “roll off” (mature without replacement). The yield curve almost immediately ticked into an inverted state, recovered briefly and then two months later entered the longest period of inversion in history. It only ended in September 2024, just when the Fed began reducing the Fed Funds target rate. By then this process of “quantitative tightening” (QT) had reduced the Fed’s balance sheet by almost $2 Trillion.

In the 11 months since the first rate cut, another half a trillion dollars of bonds have rolled off – in effect, removing a half a trillion dollars of demand from the bond market. Less demand means lower prices, which means higher yields. How much higher? One recent study calculated that a $1 Trillion reduction in the Fed’s bond holdings would increase the 10-year Treasury yield by 200 basis points – which is almost exactly what we see (half a trillion dollars => 100 basis points rise in yields).

The Fed is pursuing two contradictory policies at the same time. It is attempting to ease credit conditions by cutting interest rates, and it is tightening credit conditions through QT.

To return to the previous metaphor — maybe the gas pedal on this vehicle isn’t broken. Maybe it’s just that the Fed is driving with one foot on the gas and one on the brake at the same time.

Summary

Market interest rates have not responded to the past three interest rate cuts in the way policy makers at the Federal Reserve intended. Instead of lower borrowing costs, the result has been significantly higher cost of credit for consumers and businesses in all the most important categories: Treasury bonds, corporate bonds, mortgage rates.

Should we expect a different outcome from the next rate cut in September (or whenever)? Does the Fed’s interest rate policy still have a meaningful influence over broader credit conditions? Current evidence would say No.