The Federal Reserve is Becoming Relevant Again
On September 26 the Federal Reserve raised a "key interest rate", continuing a string of eight rate increases since 2015. Media coverage indicated some consumer and business loans use this "key" rate as a benchmark and might also lead to increases in other interest rates. On the premise most adults have only a vague idea of what's happening other than interest rates are rising, and the Fed has something to do with it, let me try to explain what's going on. And why I wrote in the headline The Federal Reserve is Becoming Relevant Again. I'll use two or three more blog postings to put the Fed's actions into context.
From the mid-point of the housing and mortgage market collapse in about 2008 until 2015, short-term interest rates--including this "key" rate supposedly "raised" this week by the Fed--fell dramatically and stayed at zero or near zero until 2015. During that period, from a monetary policy point of view the Fed became irrelevant because they couldn't push rates below zero and there certainly was no reason to raise rates. During that period also, I was fascinated by Fed spokesmen who were cheerleading for more inflation, to be interpreted as a sign of a recovering economy, contrary to the Fed's historical position of tolerating low (under two percent) inflation and fighting to reduce inflation if it exceeded two percent. So now, by being in a position to push interest rates higher to temper economic growth and rising prices, the Fed has a job to do. And it is relevant again. Their seven year itch to get back into the game (2008 - 2015) is over.
A definition first: the key interest rate referred to is known as the "fed funds rate". It basically is the interest rate at which commercial banks borrow from one another overnight (hence short-term) in order to manage their liquidity positions on a day-to-day basis. Second, the Federal Reserve does not literally "raise" the fed funds rate. Rather, by buying government securities to put into its portfolio the Fed gives money to those from whom it buys the securities, who in turn deposit the money into a bank account, thereby increasing the supply of fed funds the banks have relative to any level of demand for fed funds. Conversely, by selling government securities from its portfolio, the Fed takes money from investors in exchange for the securities those investors are buying from the Fed.
To simplify: if the Fed buys securities it pumps money into banks, which tends to lower the fed funds rate. If the Fed sells securities it absorbs money out of banks, which tends to raise the fed funds rate. Since 2015, the fed funds rate increases would have occurred because the Fed started selling more securities than it was buying, thereby being a net seller of securities and reducing or slowing the growth in deposits in banks even as the economy began to expand. An expanding economy generally means banks need more liquidity to manage their lending and other activities (increased demand for fed funds), but the Fed was reducing the amount of fed funds by being net sellers of securities (decreasing supply of fed funds). When the demand for most anything increases but its supply either shrinks or rises more slowly than demand is increasing, the price of that item will increase. In this case the item is money and the cost of money, its price, is expressed in terms of interest rates.
Conclusion: the Fed did not "raise" this key interest rate. By buying and selling government securities the Fed helped cause the supply of fed funds available in banks to fall below the demand for fed funds by banks wanting to borrow them, so the price of fed funds--the fed funds interest rate--
increased. Two future blogs: First: how do increases in the fed funds rate affect other interest rates? Second: were short term interest rates being near zero for seven years good or bad for the economy?
From the mid-point of the housing and mortgage market collapse in about 2008 until 2015, short-term interest rates--including this "key" rate supposedly "raised" this week by the Fed--fell dramatically and stayed at zero or near zero until 2015. During that period, from a monetary policy point of view the Fed became irrelevant because they couldn't push rates below zero and there certainly was no reason to raise rates. During that period also, I was fascinated by Fed spokesmen who were cheerleading for more inflation, to be interpreted as a sign of a recovering economy, contrary to the Fed's historical position of tolerating low (under two percent) inflation and fighting to reduce inflation if it exceeded two percent. So now, by being in a position to push interest rates higher to temper economic growth and rising prices, the Fed has a job to do. And it is relevant again. Their seven year itch to get back into the game (2008 - 2015) is over.
A definition first: the key interest rate referred to is known as the "fed funds rate". It basically is the interest rate at which commercial banks borrow from one another overnight (hence short-term) in order to manage their liquidity positions on a day-to-day basis. Second, the Federal Reserve does not literally "raise" the fed funds rate. Rather, by buying government securities to put into its portfolio the Fed gives money to those from whom it buys the securities, who in turn deposit the money into a bank account, thereby increasing the supply of fed funds the banks have relative to any level of demand for fed funds. Conversely, by selling government securities from its portfolio, the Fed takes money from investors in exchange for the securities those investors are buying from the Fed.
To simplify: if the Fed buys securities it pumps money into banks, which tends to lower the fed funds rate. If the Fed sells securities it absorbs money out of banks, which tends to raise the fed funds rate. Since 2015, the fed funds rate increases would have occurred because the Fed started selling more securities than it was buying, thereby being a net seller of securities and reducing or slowing the growth in deposits in banks even as the economy began to expand. An expanding economy generally means banks need more liquidity to manage their lending and other activities (increased demand for fed funds), but the Fed was reducing the amount of fed funds by being net sellers of securities (decreasing supply of fed funds). When the demand for most anything increases but its supply either shrinks or rises more slowly than demand is increasing, the price of that item will increase. In this case the item is money and the cost of money, its price, is expressed in terms of interest rates.
Conclusion: the Fed did not "raise" this key interest rate. By buying and selling government securities the Fed helped cause the supply of fed funds available in banks to fall below the demand for fed funds by banks wanting to borrow them, so the price of fed funds--the fed funds interest rate--
increased. Two future blogs: First: how do increases in the fed funds rate affect other interest rates? Second: were short term interest rates being near zero for seven years good or bad for the economy?
Very good - I look forward to the next
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