Summary: Here’s another in my series of economic myth-busting articles, explaining that the Fed is not suppressing rates. It is a follow-up to Ignore The Bond Bears, The Fed Will Not Raise Rates.
Part of the magical, even divine, powers attributed to the Federal Reserve is their ability to set interest rates — both short- and long-term. Since the quantitative easing ended we have seen this taken to the logical extreme — with the Fed suppressing rates without visible action! In physics that’s quantum mechanics. In finance it is mythology.
Economists, both Left (e.g., Paul Krugman) and Right (e.g. Tyler Cowen) acknowledge that the post-crash low rates do not result from the Fed’s action. They do so for good reason.
The Fed is not buying bonds — their most effective (almost the only effective) means of depressing interest rates. QE3 ended on 29 October 2014. Two years ago. On that day total Federal Reserve assets were $4,487 billion. As of 19 October 2016 they were $4,467 billion. See the graph.
In theory the Fed could affect prices by buying and holding a substantial fraction of the $64 trillion in outstanding US debt and loans. Taking the fraction they own from 3% to 6% over 7 years (2008-2014) did not seriously change the bond market’s structure. Perhaps the structure of credit spreads differs from what it might have been if the Fed had not added the Treasury securities and government-guaranteed mortgages. It’s difficult to determine such things. But it the effect on credit spreads, if any, is unlikely to have affected interest rates.
If the Fed is not suppressing rates, why are they so low? Fed Vice-Chairman Stanley Fischer explains in this speech on 17 October.
When will the Fed normalized rates?
This assumes today’s rates are not normal? They are set by the market. What other standard is there?
People always want different rates, and construct reasons why their desired rates are “natural”. Lenders want them higher. Borrowers want them lower. The permanent chorus of inflation alarmists — for them, inflation is always coming, with hyperinflation lurking under the bed (as Depression was for their parents) — always want higher rates (only their reasons change).
How will the Fed raise rates?
Stating their target for Federal Funds does almost nothing, except set expectations for other Fed actions. What did they do to raise rates after their 16 December 2015 announcement increasing the target rate to 25 – 50 bps? How do they plan to raise rates, eventually?
We need not guess, because the Fed is among the most transparent of Federal agencies. They will change the Interest on Required Balances and Excess Balances (aka IOER).
“The FOMC has stated that the IOER rate will be a primary tool during the normalization period. Depository institutions should be unwilling to lend to any private counterparty at a rate lower than the rate they can earn on balances maintained at the Federal Reserve. As a result, an increase in the IOER rate will put upward pressure on a range of short-term interest rates” (Source: Fed, 11 May 2016.)
Accordingly they increased the IOER rate from 25 bps to 50 bps on 17 December 2015. The IEOR is and has been the same as the upper target for Fed Funds. The actual Fed Funds rate, set by bidding among banks — plus intervention by the Fed — varies between the Fed’s lower and upper targets.
The IEOR pushes rates up, providing a competitor for funds. It cannot suppress rates. The Fed also uses treasury repurchase agreements to tweak rates (it cannot push them far).
See this page on Fed’s website for more about their plan to “normalize” rates. They define “normalization” as:
“steps to raise the federal funds rate and other short-term interest rates to more normal levels and to reduce the Federal Reserve’s securities holdings.”
This assumes, as almost everybody does, that the current conditions are an aberration — and that soon conditions will return to the post-WWII averages. That is probably wrong, as explained here.
What happens next?
With the economy running slow and slowing, how might the Fed raise rates? If the Fed is suppressing rates, what do they stop doing to allow rates to rise?
More realistically, the Fed would have to restart open market operations to raise rates. They could shrink their massive balance sheet to push up rates to whatever level they desire. This would be a hammerblow to the economy. That would be stupid. The Fed’s governors and professional staff are not stupid.
Rates are not going up in the foreseeable future.
For More Information
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- The secret but vital to know number in today’s economic news – per capita GDP.
- To understand the jobs report, see the state of the economy.
- About the new jobs report: Ignore The Bulls And Bears – See The Key Trend In The Jobs Numbers.
- Ignore The Bond Bears, The Fed Will Not Raise Rates.
- More Evidence That The Fed Will Not Raise Interest Rates.
- Why New Home Construction Is Slow, And Will Remain So For A Long Time.
Well written and insightful, as usual. The only (extremely flimsy) evidence that people who believe the Fed is suppressing rates can cite is the speeches from the individual Fed governors who favor raising rates which are followed by decisions choosing not to do so.
There is no doubt that the Fed governors wish that the circumstances allowed them to normalize the rates but their response to the situation at hand has been about as good as possible (although I wish they had turned off the QE spigot sooner).
The Fed has been far better than Europe and will likely be seen by later generations as better than either China or Japan.
Pluto,
“The only (extremely flimsy) evidence that people who believe the Fed is suppressing rates can cite is the speeches from the individual Fed governors who favor raising rates which are followed by decisions choosing not to do so.”
Why is that evidence? Some governors (three at the last meeting) voted to raise rates. They have votes, but no governor is God.
“although I wish they had turned off the QE spigot sooner).”
Why? QE3 had no apparent ill effects. Didn’t do much either, but was worth trying.
“The Fed has been far better than Europe”
It would take divine intervention to run an effective central bank in the loose federation of the European Monetary Union.
“and will likely be seen by later generations as better than either China or Japan.”
Color me skeptical on both of those. I doubt the Bank of Japan could have influence events better than they did. As for China, it is too soon to say. They have a complex situation; we can only guess at the outcome.
You are right that “evidence” is too strong a word for the speeches.
On QE: if something isn’t doing very much good in spite of injecting over $1 trillion into the economy, you should probably stop sooner than later.
Agreed on the EU but I continue to be dismayed by the damage they are doing to themselves and impressed by the willingness to keep slogging down a trail that looks less and less successful.
Japan as been in a horrible place since the late 1980’s and I share the fears that the rest of the world might be sliding into the same place but am not yet convinced that such a slide is inevitable. The Fed has done its best to learn from the mistakes of the Japanese in the last 30 years. On the other hand, I doubt that the Fed could have done any better than the current Japanese central bank in a similar situation, the horrible past limits future options.
In the short-run color me skeptical on the Chinese. As you say, their situation is very complex and the lack of transparency makes identification of the correct economic policies, much less implementing them, impossible. In the longer run I tend to agree with you that the Chinese might even become a superpower.
Pluto,
“if something isn’t doing very much good … you should probably stop sooner than later.”
Is that what you would say to a doctor treating your critically ill daughter? Or would you want doctors to use every remedy, even if marginally effective.
“In the short-run color me skeptical on the Chinese.”
Even Western experts know little about China, so that making short-term forecasts is difficult (even more so than for western nations).
“their situation is very complex and the lack of transparency makes identification of the correct economic policies, much less implementing them, impossible.”
That’s quite false. I personally know several world-class economists who cover China. None of them believe that.
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