The Fed’s Conundrum: Interest Rates Are Both Too High—and Too Low

The Federal Reserve is still aiming to lower interest rates later this year, and for many U.S. households and small businesses those rate cuts can’t come soon enough. But for big companies able to tap the corporate bond market, and for investors riding a rising stock market, relief from the Fed doesn’t seem all that necessary.

The Fed on Wednesday left its federal-funds rate target steady at a range of 5.25% to 5.5%, the highest level in more than two decades. But it left in place plans to cut interest rates this year. Fed Chair Jerome Powell again characterized the level of rates as “restrictive,” and said that “it will likely be appropriate to begin dialing back policy restraint at some point this year.” 

Changes in the Fed’s benchmark fed-funds rate have a strong effect on a variety of short-term rates, such as those on bank deposits and money-market funds. But their influence on longer-term rates, such as those on corporate bonds, can be more tenuous.

The idea that the Fed’s target rate is restrictive is driven by a variety of models, many of them versions of the Taylor rule put forth by the Stanford economist John Taylor. These calculate where the Fed should set rates based on its inflation target, current inflation, estimates of how much slack there is in the economy, and estimates of where rates will eventually need to settle. Three versions of the rule calculated by the Atlanta Fed suggest the Fed’s target rate should now be 3.9% to 4.7%.

A lot of Americans probably don’t need to consult the Taylor rule to conclude rates are restrictive: They can just look at the interest their credit-card accounts are charging. The average interest rate on commercial bank credit-card plans in the fourth quarter was 21.5%, according to the Fed. That is the highest in the 30 years of available data, and compares with just 14.9% in the fourth quarter of 2019, right before the pandemic hit.

Recent research from former U.S. Treasury Secretary Larry Summers and co-authors suggests that households’ high borrowing costs might even help explain what has been a bit of a mystery: Why, despite a strong job market and moderating inflation, consumer moods remain so dour.

Small businesses, too, often tap credit cards, with a recent Fed survey finding that 56% of them regularly used cards for financing—more than any other source of credit. Lines of credit, also commonly used by small businesses, are also tied to short-term rates. Constraints on small businesses can translate into less robust job growth. Companies with fewer than 100 employees account for about a third of private employment, while research has shown that young, small businesses on the way to becoming larger ones are a deciding factor in U.S. job growth.

But long-term interest rates aren’t nearly as elevated relative to before the pandemic as the overnight rate the Fed targets. The yield on the 10-year Treasury note has lately been at around 4.3%. While higher than before the pandemic, historically that isn’t very high—and it is significantly lower than the 5% it touched last fall.

In February 2005, Fed Chair Alan Greenspan pronounced the low level of long-term rates relative to short-term rates a “conundrum.” Back then, long-term rates were about where they are now, with the 10-year yield around 4.2%. But the Fed’s target on overnight rates was much lower, at 2.5%. 

The relatively low level of long-term rates is in part driven by investors’ expectations that the Fed will at some point be lowering rates, but might also reflect a belief among investors that the central bank will be steadfast in its efforts to bring inflation under control, according to Duke University economist Anna Cieslak.

A recent textual analysis of Fed meeting transcripts from 1987 through 2015 that she conducted with the University of Oxford’s Michael McMahon finds that when policymakers adopt a more hawkish stance on rates, term premiums go lower. They are the components of Treasury yields that reflect everything other than investors’ baseline expectations for short-term interest rates.

“We may be seeing sort of a return to some of the past experience where the Fed was credible on controlling inflation,” she said.

Investors don’t just seem to think that the Fed will be able to bring inflation under control, but that it will do so without sending the economy into a recession, and that is being reflected in low corporate bond yields and a soaring stock market. The difference, or spread, between Treasury and corporate bond yields is narrower than at nearly any time during the decade before the pandemic. Stocks have been logging new highs, and the S&P 500 is up by more than 30% from a year ago.

One place where long-term rates still seem high is the one that matters most to many households: Mortgage rates are much higher than before the pandemic, and the spread between them and Treasury yields has widened. High mortgage rates have locked many renters out of homeownership. 

The result is that large companies that can tap the public markets are experiencing easier funding terms than many small businesses and households, while investors’ growing stock-market wealth is providing another economic tailwind. Measures put together by Goldman Sachs and the Chicago Fed, among others, show that overall U.S. financial conditions have been getting less restrictive. The Fed’s own index, which is based on an array of measures including overnight rates, bond yields, mortgage rates, and home and stock prices, shows that conditions in January were at their least restrictive since August 2022.

Ultimately, what the policymakers can most directly control is short-term rates, notes Johns Hopkins economist Jonathan Wright, and they believe those rates are restrictive enough that even if they cut rates, it will be more akin to easing off the brakes than putting their foot on the accelerator. 

On the other hand, “They don’t want the stock market to go up another 10% from here,” he said. 

All three major U.S. stock indexes hit new highs on Wednesday.

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