Raising Rates: Just How Will the Fed Do It?
Everyone seems to assume that if the Fed decides to raise the short term interest rate, all they will have to do is wave their wand and the rate will magically go where they want. Historically, that's not how it was done. The Fed sold securities into the market, reduced liquidity and the market took the rate higher.
Raising Rates: Just How Will the Fed Do It?
Everyone seems to assume that if the Fed decides to raise the short term interest rate, all they will have to do is wave their wand and the rate will magically go where they want. Historically, that's not how it was done. The Fed sold securities into the market, reduced liquidity and the market took the rate higher.
The basic free market principle is that holders of liquidity such as money market funds can demand a higher return on their money in a period of growing scarcity of short term funding. Can the Fed suspend this principle and take central planning to the next level?
It is generally agreed that a quarter point increase in the short term rate will not affect the economy. Capital spending on plant and equipment has been dead in the water for years and in any case depends on longer term rates. Share buy-backs are typically financed longer term, often outside the US, in weaker currencies. Longer term rates have proved to be impervious to Fed monetary policy. What corporate borrowers will not borrow, or will borrow less, because of a small increase at the short end?
For consumers, new borrowing is constrained by balance sheet weakness, poor loan demand and stricter bank credit policies more than the interest rate. The one exception to low loan demand is the sub-prime credit bubble supporting the automotive boom but this anomaly also depends on longer term rates.
Financial markets are another matter. Leverage is enormous and liquidity appears to be drying up, contributing to immense volatility. For hedge funds and other leveraged players, short term rates and, more importantly, the availability of short term funds for roll-overs, potentially have life or death significance. Is this why the Fed has proved reluctant to raise rates, at least until now?
So, how will the Fed increase rates, if it actually does so? The Fed wants us to think that by raising the rate of interest it pays to commercial banks on their deposits at the Fed, somehow that will make these banks charge their customers more. The Fed got the right to pay interest on deposits in 2009, presumably to give them the ability to raise rates without reducing their balance sheet, which would shrink liquidity.
If the Fed pays the banks more income, in effect a bigger subsidy that lowers their net cost of funds, will those banks be able and willing to charge their customers more if they are still holding vast reserves at the Fed? Without reducing the supply of funds in the system, will the rate increase be effective?
Or will paying a higher rate on deposits at the Fed actually prove to be an incentive for banks to increase Fed deposits and reduce funds available to their customers? This would reduce market liquidity.
We are now in uncharted waters. Perhaps the 'how' of a Fed increase is more important than if or when, as this chart suggests (from Crosscurrents at http://www.cross-currents.net):
This chart illustrates the difference between total mutual fund cash reserves and total margin debt. To compute cash, multiply total assets in equity mutual funds by the percentage of cash reserves. Then subtract total margin debt as provided by the NASD, which includes NYSE margin debt.