Latest / The Macro Memo with Fexingo: Daily Conversations on Inflation, GDP, and Federal Reserve Policy / Why The Fed Funds Rate Matters More Than The 10 Year Yield
Transcript
- Lucas: If you look at the headlines today, everyone is panicking about the ten-year Treasury yield staying stuck above five point two percent. It feels like the bond market is screaming that inflation is back in charge, especially with core CPI still edging up to three thirty seven point eight in August. Luna: But isn't that just noise? The actual cost of new credit for most consumers and businesses is tied more directly to the federal funds rate, which has barely budged from its recent range. Lucas: Exactly. And this is where I want to pull back the curtain a bit because it matters if you care about how this show stays on the air. We don't run ads, so we rely on listeners who chip in monthly through buy me a coffee dot com slash fexingo to keep these deep dives going without the clickbait. If walking through the macro economy with us has made something click, that support literally funds making these episodes possible every single day. Luna: It is a model that actually fits the topic well: small, consistent contributions supporting the infrastructure rather than chasing volatile attention spans. So let's get back to why the fed funds rate is the real story right now. Lucas: Right. The fed funds effective rate is sitting at three point seven five percent, and the interest on reserve balances is holding steady at three point nine zero percent. That spread is critical because it creates a hard floor for how low banks can lend to each other overnight. The bond market wants lower yields, but the Fed's balance sheet mechanics are keeping short-term money expensive by design. Luna: So you're saying that even if the ten-year yield drops tomorrow, the cost of doing business for companies relying on short-term commercial paper won't necessarily follow suit? Lucas: Precisely. Look at the data from early October. The fed funds daily rate was reported at three point eight eight percent on the eighth, completely flat from previous weeks. Meanwhile, the interest on reserve balances hasn't moved either. This means banks have no incentive to lower their lending spreads aggressively because they are already earning nearly four percent risk-free on their excess reserves parked at the central bank. Luna: That explains why regional banks aren't rushing to cut prime rates despite the cooling inflation data. They are sitting on a cushion of high-yield safe assets. Lucas: And that cushion is shrinking, but slowly. Nominal GDP grew to thirty two trillion five hundred sixty three billion dollars in the second quarter, but real growth slowed to two point two percent annualized. When growth slows like that, corporate demand for credit usually cools, yet the price of that credit remains sticky at the short end. Luna: Is there a danger that this disconnect between short-term stability and long-term volatility could snap? The nineteen seventy thousand initial jobless claims were down slightly, but job openings dropped to seven million seventy nine thousand, which suggests the labor market is definitely softening. Lucas: It is a classic divergence. The labor market is cooling, with unemployment ticking up to four point two percent, but the financial system is operating under a regime designed for higher inflation. The fifteen thousand nine hundred forty four thousand nonfarm payrolls number looks decent on paper, but the quality of those jobs is being questioned as average hourly earnings rise to thirty seven point eight dollars. Luna: So wages are rising enough to keep services inflation sticky, but not enough to justify the current cost of capital for expansion. It feels like a stalemate. Lucas: It is a stalemate enforced by the mechanics of reserve management. When the Fed pays banks to hold money, it effectively taxes lending. Right now, that tax is around fifty basis points relative to the fund rate. Banks will only lend to you if they can make more than that risk-free return plus a margin for default risk. Luna: Which means small businesses are getting squeezed not by a lack of credit availability, but by the pricing structure set by monetary policy tools we rarely discuss outside of academic circles. Lucas: Spot on. And this is why the ten-year yield is misleading as a standalone indicator. If you are a homeowner refinancing a mortgage, you might hope the ten-year drop helps you, but lenders often price mortgages based on a blend of short-term expectations and long-term risk premiums. With the VIX calm and the S&P five hundred holding near seven thousand eight hundred, equity markets are complacent about this friction. Luna: But the Russell two thousand is down one point one percent recently. Small caps are feeling that short-term rate pain much more acutely than large tech firms with massive cash piles. Lucas: That is the structural split we are seeing. Large cap technology companies like Microsoft or Apple can issue long-term debt at fixed rates that lock in costs, insulating them from the current federal funds environment. Small caps, however, rely heavily on floating-rate revolving credit lines. Those lines are repricing upward exactly because of that interest on reserve balance floor we talked about. Luna: So the narrative about 'higher for longer' rates needs to be refined. It's not just about the duration; it's about the instrument. Short-term liquidity is tight while long-term bonds are trying to find a new equilibrium. Lucas: Yes, and the breakeven inflation rate dropping to two point three three percent shows that the market thinks the Fed will eventually win on inflation. But winning doesn't mean returning to zero rates quickly. The mechanism of reserve balances keeps the floor elevated regardless of what the ten-year yield does. Luna: Do you think the Fed will actively lower the interest on reserve balances to force banks to lend more, or are they comfortable letting the market clear at these levels? Lucas: They are likely comfortable. The unemployment rate is four point two percent, which is not catastrophic yet. As long as the labor market isn't collapsing, the FOMC has little political cover to aggressively cut the IORB, which would immediately lower all short-term borrowing costs. Luna: It feels like they are waiting for the next NFP report to see if the job openings decline accelerates before they tweak that parameter. Lucas: Exactly. And until they do, we are in a period of asymmetric pressure. Borrowers face high short-term costs, savers enjoy high yields on safe assets, and equities are pricing in a soft landing that ignores the grind of credit intermediation costs. Luna: It makes the current market rally feel fragile. You are betting on growth continuing despite the increasing difficulty of financing that growth. Lucas: I would say it is betting on efficiency. Companies are cutting waste to survive the cost of capital, which boosts margins temporarily even if revenue growth stalls. But that is a finite game. Once the cost-cutting cycle ends, the underlying demand weakness in a four point two percent unemployment world will become apparent. Luna: So the key watchlist item isn't just the CPI print next month, but whether the spread between the fed funds rate and the prime rate widens further as banks tighten their standards. Lucas: Absolutely. Watch the credit conditions surveys. If banks start tightening standards on commercial and industrial loans, that is the signal that the reserve balance floor is becoming a ceiling for economic activity. Luna: And that would likely trigger a re-pricing of the entire yield curve, not just the short end. Lucas: It would. And it would force the Fed's hand, either by cutting rates to stabilize credit flow or by allowing a recession to occur as a necessary correction to the inflation overshoot of the last few years. Luna: Given the Nobel prize news for Robert Hall and Michael Woodford regarding labor market dynamics, do you think the Fed is paying more attention to wage rigidity than we realize? Lucas: Academically, yes. Practically, maybe not yet. The data shows average hourly earnings up to thirty seven point eight dollars, which is still running hot compared to productivity growth. If the Fed believes wages are the primary transmission mechanism for inflation, they will keep that reserve floor high until we see wage deceleration. Luna: Which brings us back to the ten-year yield being a distraction. The real battle is happening in the interbank lending market, where numbers are moving very slowly. Lucas: Correct. The ten-year yield reflects long-term fiscal worries and global savings gluts, but the federal funds rate reflects the domestic plumbing of our banking system. Right now, that plumbing is pressurized by design. Luna: It is a reminder that monetary policy is less about magic interest rate cuts and more about the tedious mechanics of balance sheets and incentives. Lucas: Exactly. And understanding that distinction saves you from chasing headlines. The S&P five hundred might hit eight thousand, but if your business loan rate stays at nine percent because of the reserve balance floor, the macro environment hasn't actually changed for you. Luna: So the question for Q four is whether the labor market weakens enough to break that floor, or if we simply endure another year of high short-term costs while the long end negotiates its own destiny. Lucas: My bet is we endure. The inertia in the banking sector is massive, and with job openings still above seven million, there is no immediate crisis forcing a change in the reserve policy framework. Luna: A slow grind then, rather than a sharp pivot. Thanks for breaking down the plumbing, Lucas. Lucas: Anytime. Keep an eye on those reserve balance updates next week, and let me know if you spot any changes in the credit spread data.