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
If you liked this post, like us on Facebook and follow us on Twitter. See all posts about economic growth, about the Federal Reserve, about monetary policy, about secular stagnation, and especially these…
- Why Investors Are Deceived By News About The Economy.
- 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.
