Course · Act II: Hedge the Book · Chapter 6

The Fed and interest rates

How the Fed sets the federal funds rate, why short yields follow it and long yields don’t, how markets price hikes before they happen, and what quantitative easing and tightening do.

The federal funds rate

The federal funds rate is what banks charge each other to lend reserves overnight. The Fed’s rate-setting committee, the FOMC, meets eight times a year and sets a target range for it, such as 5.25–5.50%. Every other dollar rate starts from there.

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The Fed steers the rate with interest on reserve balances (IORB): what it pays banks on money parked at the Fed. No bank lends overnight for much less than it can earn, risk-free, from the Fed itself. Move IORB and the federal funds rate follows.

Short end, long end

Bills and 2-year notes track the federal funds rate closely, because they are short bets on where it will be. Long yields price the average short rate over many years, plus a little extra for the wait. From March 2021 to March 2023 the 2-year rose 492 basis points; the 10-year, 253.

Ahead of the Fed

Markets move before the Fed does. On 8 March 2023 the target range was 4.50–4.75%, yet the 6-month bill yielded 5.34%: investors expected more hikes and had priced them in. A hike everyone expects barely moves the curve on the day.

QE and QT

The Fed can also reach the long end directly. Quantitative easing (QE) is the Fed buying long Treasuries and mortgage-backed securities, which pushes long yields down. Quantitative tightening (QT) is the reverse: letting them mature without buying new ones.

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Key terms

Federal funds rate: The overnight rate banks charge each other. The FOMC sets a target range for it, eight meetings a year.
Interest on reserve balances (IORB): What the Fed pays banks on money held at the Fed. The lever that keeps the federal funds rate in its range.
Quantitative easing / tightening: QE: the Fed buys long bonds, pushing long yields down. QT: it lets them mature without replacing them.

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