Who Really Sets Interest Rates? Every investor watches the Fed. The data suggests they are watching the wrong thing.
Watching the Wrong Lever When clients ask us about interest rates, the conversation almost always orbits the same body: the Federal Reserve. Will the Fed cut at its next meeting? What did the “dot plot” signal? Is Fed Chair Kevin Warsh, who succeeded Jerome Powell in May, more hawkish or dovish than his predecessor? It is easy to understand why everyone asks these questions. The Fed is the most visible actor in the rate story – it earns the headlines and markets visibly lurch around its meetings. The instinct that the Fed sets the price of money in the economy is nearly universal among investors. It is also, for the rate that matters most, largely mistaken. The yield that anchors mortgages, corporate borrowing costs and the discount rate underneath every stock in your portfolio is the 10-year U.S. Treasury yield, and the Fed does not set it. The market does. More specifically, the market prices the 10-year off two fundamentals: how much inflation it expects and how fast it expects the real economy to grow. This piece makes that case with seven decades of data.
What the Fed Actually Controls The Federal Reserve sets one interest rate directly: the fed funds rate, the overnight rate that banks charge each other to borrow reserves. That is the lever. Everything else (the 2-year note, the 10-year, the 30-year bond, the mortgage you sign) is set in open markets by buyers and sellers, not decreed by the Fed. The Fed’s grip is firmest at the very short end of the curve and loosens steadily as maturities lengthen. By the time you reach the 10-year, the Fed’s overnight rate is only one input among many. The 10-year yield is a market-clearing price that reflects what millions of investors collectively expect inflation and growth to average over the next decade. Chairman Warsh can influence that expectation at the margins, but he cannot set it. He is only one voice in a very large room.
Inflation Plus Growth: The Intrinsic Rate There is a clean way to frame this relationship, sometimes called the intrinsic rate, a concept that valuation professor Aswath Damodaran has written about at length1. Over time, a lender requires compensation for two things: the expected loss of purchasing power to inflation and the real return the broader economy can support. Add those together and you get the rate that long-term bonds should gravitate toward:
Intrinsic rate = expected inflation + expected real growth
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