A reader wrote in response to last week’s blog whether the significant fall in the Federal Reserve’s discount rate would translate into lower rates on credit cards and other interest-consuming liabilities. The clear answer is sorta. 

In fact, nobody can actually borrow from the Federal Reserve. Only nationally chartered and some other commercial banks are eligible to borrow and only to prop up their cash reserves to sufficient levels as federally mandated should they temporarily fall short. Even banks cannot use the Fed’s lending largesse to borrow long term so they can lend the money out at a higher rate. 

Banks have one other option for short term borrowing. They can lend and borrow to each other in the “overnight” market, but that facility is such a close substitute to the Fed’s discount window that the rates are quite aligned. 

Almost no person with good credit needs to borrow overnight or for very short terms. Instead, we borrow to buy a home and take out a student loan long term, or perhaps buy a car or do home improvements medium term. Some may even rely on their credit card to stretch payments out over a few months. All of these credit markets have much longer durations than that intended by the Fed’s lending to banks. 

Hence, we would not expect the Fed’s very short term interest rate to be comparable to other lending rates, even if it may somewhat influence them. Usually the Fed rate that dropped to around 5% last week is lower than other prevailing rates. The reason is that there is less lending risk in short term lending. On the contrary, many things can happen over a 10 year or 30 year period, such as periodic high inflation that adds riskiness and detracts value from long term lending. 

It should come as no surprise, then, that the Fed’s rate is usually a bit lower than prevailing interest rates. Today’s chart shows how these interest rates compare, with the bellwether 10-year treasury bond yield usually priced about 2 percentage points (200 basis points) above the Fed’s rate on average. 

The graph also shows that on unusual occasions the Fed’s short term rate to banks is actually higher than the yield on medium-long term rates. That happens on the rare occasion when the Fed rapidly cranks up its discount rate to encourage banks to keep more than enough cash reserves and hence cut back on lending. Such monetary policy is used to wring inflation out of the economy through a programmed slowdown using what economists call tight monetary policy. 

The graph also suggests another interpretation. It appears that the Fed often increases its interest rate a little after longer term interest rates begin to rise, and drops its rate following falls in market interest rates. In other words, the Fed may be more reactive than proactive. When financial markets sense a decline in economic activity, people shift their assets out of stock and more into bonds, which raises the price of bonds and lowers their yield. By the time the Fed recognizes the slowdown and lowers its rate to help bolster the economy, markets have already “priced in” that move in anticipation. 

Likewise, markets seem to equally anticipate an increase in the Fed’s discount rate. Because the Fed makes decisions with the significant policy and data lag we have often documented in this blog, one could argue the Fed is less influencing lending markets and more reacting to them. 

The 10 year treasury rate is thus perhaps the best barometer of lending and economic activity. For instance, mortgage rates have come down substantially over the past few months in anticipation of the eventual normalizing of interest rates. The Fed has stated it is determined to lower its discount rate another 50 basis points or more, perhaps by the end of the year. In doing so, it is sending out a message that it is determined to stimulate the economy, and this is what financial markets will absorb by making it less risky to lend again. That should help lower interest rates still further. 

Some interest rates will not change, though. Credit card rates are published well in advance, and are usually at very high rates since those who tend to rely on card credit have few alternatives. Those rates tend to remain high always. There are also some rates set legislatively, such as rates for loans through government programs such as disaster relief, small business, and other subsidized products. These rates are often below market and respond only a little to market forces. 

It should then come as no surprise that the reactive Fed rate does not really set other interest rates, but instead indicates the trends of other rates. Its announcement of trends is influential but not determinative. What is most important is the statement the Fed is making with regard to which direction it shall steer the economy. 

Once it makes that statement, other Fed actions are far more important. The Fed sometimes follows up such statements with actions to buy and sell bonds, including the bellwether 10-year treasury bond. Because the Fed can be the whale in the pond, given its almost limitless capacity to buy and sell bonds on the open market. 

It is such open market operations by the Fed that I will be following. That is where the Fed really puts its money where its discount rate mouth is, and can ultimately affect the interest rate that most profoundly affects us all.