Many people believe that longer-term interest rates will rise when a tightening policy by the Federal Reserve begins. However, history shows that short and long-term rates do not move in lockstep.

There have been periods when the Fed aggressively lifted the fed funds target rate—the short-term rate controlled by the central bank—while longer-term rates did not change or “stubbornly” declined. A good example is the Fed’s last campaign of policy tightening through the use of the fed funds target rate.

From 2004 to 2006, the Fed increased the rate by 4.25%, yet longer-term rates experienced a period of decline. Alan Greenspan, Fed chairman at the time, referred to this phenomenon as a “conundrum.”

When analysing the Fed’s impact on short-term rates, we must also consider the unprecedented action taken by the Fed since 2008—its massive issuance of reserves paying rates of interest.

Prior to 2008, the Fed paid no interest to banks on excess reserves thus; there was an opportunity cost for banks depositing excess reserves at the Fed. This opportunity cost naturally encouraged banks to make loans and purchase securities; the availability of loans and the money supply created by banks purchasing securities created downward pressure on interest rates.

The Fed’s recent policy of paying interest rates on excess reserves removed the previous opportunity cost, assuming available rates in the market are not higher than what the Fed is paying.

Due to a lack of attractive spreads on loans in the current market, holding excess reserves at the Fed seems now the more attractive option. Conventional wisdom has been turned on its head.

By paying interest on excess reserves, the Fed has, in essence, created new “short-term securities.” The issuance of these reserves, or “short-term securities,” pulls monetary supply out of the economy, which by definition should raise interest rates.

The question then becomes: Has the Fed really been trying to keep interest rates low? It does not seem that way. Perhaps, in an effort to fight deflation, the Fed has actually been trying to push interest rates higher, yet the lack of attractive lending opportunities in the market has flooded banks with deposits, pushing interest rates lower and limiting the power of the Fed.