But why, JW? Why "The past 25 years"??

I think of finance as a competitor of the Federal Reserve, when it comes to providing funds to the economy. It follows that the growth of finance, the relative size of finance, and the deregulation of finance play a role in the outcome of that competition.

At The Slack Wire, JW Mason writes:

Textbook macro models, including the IS-LM that Krugman is so fond of, feature a single interest rate, set by the Federal Reserve. The actual existence of many different interest rates in real economies is hand-waved away with "risk premia" -- market rates are just equal to "the" interest rate plus a premium for the expected probability of default of that particular borrower. Since the risk premia depend on real factors, they should be reasonably stable, or at least independent of monetary policy. So when the Fed Funds rate goes up or down, the whole rate structure should go up and down with it. In which case, speaking of "the" interest rate as set by the central bank is a reasonable short hand.

How's that hold up in practice? Let's see:

The figure above shows the Federal Funds rate and various market rates over the past 25 years. Notice how every time the Fed changes its policy rate (the heavy black line) the market rates move right along with it?

Yeah, not so much.

In the two years after June 2007, the Fed lowered its rate by a full five points. In this same period, the rate on Aaa bonds fell by less 0.2 points, and rates for Baa and state and local bonds actually rose.

I tried to duplicate Mason's graph. But I had to guess from a large selection of interest rates. Here's what I came up with. It goes back to the same start-date:

Graph #2: Collected Interest Rates (since 1987)

Eh, it's a pretty good match. (Note that I am using TB3MS, my "proxy" FedFunds series which goes back 20 years beyond FEDFUNDS. (FEDFUNDS is still on the graph, pretty well hidden by the purple line.))

Here's a look at the numbers as far back as they go:

Graph #3: Collected Interest Rates
Click for FRED source page

What I want to do is
1. drop FEDFUNDS from the data, and use the proxy data series.
2. set the proxy series apart, and average all the rest together.
3. compare the FEDFUNDS proxy to the average of the other rates.

JW Mason says market rates do not move right along with the rate set by the Federal Reserve. That is true, if we go by his graph. But his graph only goes back to 1987, and our economy was already well-financialized by then.

I think if we look farther back, to a time when we were less financialized, the graph may show that markets DID move with the Fed rate. Anyway, that's my guess.


Here's what I did:
1. Download the data in the graph, from FRED.
2. Work on the data using Open Office Calc.
3. Eliminate the early years, where there is no FedFunds Proxy for comparison.
4. Reorganize the FRED source columns: move data series with later start-dates farther to the right. (This is for my convenience in selecting cell ranges when figuring averages in Excel.)

This is a lot of data. All monthly, it is 12 times what I'm comfortable working with.

Note: The start-dates of the various interest rates differ. The corporate AAA and BAA begin well before 1934, when the FedFunds Proxy begins. MSLB20 begins in 1953Q1. GS10 begins 1953Q4. And MORTG begins in 1971Q4. The number of interest rates in the average increases as each new series begins.

Hm. I used Open Office Calc to get the size of the graph. Then I went into Paint and set the size of a new, blank picture to the same size. Then I copied and pasted. The vertical bar thickness changed. Several of the vertical bars from Calc did not show up in Paint. And the colors changed.

Graph #4: Wow, that's ugly!

Used the Windows "snipping tool" on the Calc graph, and got this version:

Graph #5: The FEDFUNDS Rate versus an Average of Other Rates

Well that's better.

I don't know if my expectation holds up. It doesn't really look as if market rates moved with the Fed rate, even before the Great Financialization. Actually, it looks like market rates are "sticky down".

The other-rates average (red) is definitely higher than the FedFunds proxy in the two Depression-times, when the FedFunds rate is near zero. And it looks to me that the red and blue are much closer on the up-swing (1946-1982) than on the downswing (since 1982). That could just be because "other" rates are not immediately responsive to changes in the FedFunds rate. (Long term, obviously, they rise and fall together.)

But maybe the two are closer on the rise than on the fall because financialization was lower on the rise than at other times. You can gage the level of financialization on Thomas Philippon's graph and mine, both presented here.  The striking fall in financialization shown on those graphs reaches a bottom in the mid-1940s, just when the up-swing begins on Graph #5.

I don't have the math skills to evaluate the result any better than that. But I can say that this evaluation of interest rates does not contradict my view that private finance competes with the Federal Reserve and that when finance grows large, it circumvents and weakens policy.