The Fed Does Not "Set" Interest Rates
The popular narrative that the Federal Reserve sets US interest rates collapses under mild scrutiny. The Fed directly controls exactly one rate — the Fed Funds rate, which governs overnight interbank lending. Every other rate that actually matters for consumer, corporate, or Treasury borrowing is set in a market where the Fed is one participant among many.
This distinction is not academic. When valuation professionals pull a risk-free rate, they pull a Treasury yield — not the Fed Funds rate. Treasury yields are determined by the market's aggregate views on inflation, real growth, and term premium.
The Fed Does Not Reliably "Lead" Markets Either
The assumption that Fed Funds changes drive Treasury and mortgage rates in the same direction is not supported by the data. Damodaran's observation:
"In the quarters following Fed Funds rate increases, US treasury rates and mortgage rates are more likely to decrease rather than increase."
This pattern suggests the Fed follows markets as often as it leads them. By the time the Fed acts, the rate-relevant information has already been digested by longer-dated instruments.
The Signaling Story Is Also Weak
The Fed publishes substantial analytical content and uses commentary as a policy tool. But the signals on inflation and growth are frequently ambiguous, and market movements often diverge from what the Fed's own statements would imply. Forecasting based on Fed communication has a mixed track record at best.
The Fed and the Equity Market
The belief that Fed actions drive the stock market is similarly oversold. Research suggests:
"The S&P 500 performs best in quarters when there is no change in the Fed Funds rate."
Rising and falling rate environments both tend to underperform flat-rate quarters. The simple "Fed cuts, stocks rip" intuition does not hold consistently.
The Chanticleer Problem
Damodaran uses the rooster fable as a framing device. A rooster crowing at dawn does not cause sunrise, even though the two events always correlate. Much of the perceived Fed influence on markets is the same pattern — Fed actions and market outcomes respond to shared underlying conditions, and the Fed's role in causing the market outcome is often overstated.
Implications for Valuation Practitioners
- Anchor your risk-free rate to observed Treasury yields, not Fed Funds
- Don't build a cost-of-capital forecast around expected Fed actions — that's a second-order input at best
- When clients ask "what happens to our valuation when the Fed cuts," the honest answer is usually "less than you think"
- Focus valuation discussions on inflation, growth, and company-specific cash flow drivers instead
Bottom Line
Central banks have less power than popular narratives attribute to them. They control one short-term rate, and their influence over broader markets operates through expectations, not command. Valuation work grounded in market-observed rates, not Fed psychology, produces more defensible and more stable outputs.