There’s currently a thread on Donald Trump’s claim that the Federal Reserve Bank is artificially keeping interest rates low. Reading through it reminded me that I don’t really understand what the Federal Reserve Bank is or does, nor what exactly these interest rates are.
Here’s the no doubt very flawed understanding I have. Feel free to correct it: the Federal Reserve Bank controls our nation’s money supply. When for whatever reason they think there needs to be more dollars in circulation, they create a bunch of dollars out of thin air, and give them to big banks. They consider this a “loan” to the big banks, and there is an interest rate on the loan. That’s what these “interest rates” are. For some reason, keeping interest rates low somehow “props up” the stock market, while raising them causes inflation. This Fed interest rate then partially determines the baseline of other interest rates across the economy: when it’s low, then savings account interest rates are low, Certificate of Deposit interest rates are low, mortgage interest rates are low, etc. When it’s high, then these other rates are high.
Assuming that’s in some sense true, what is the purpose of this? Is the Fed “charging interest” on these banks, i.e., the banks have to pay the money back to the Fed with interest? But if they do, what happens to that money? I thought the Fed created this money out of thin air? What is the purpose of all this?
I have the idea that all of this falls under the term “monetary policy,” so I suppose another way of getting at what I’m asking is to say: please explain monetary policy to me as if I were a ten-year-old.
There’s two different things that are being confused here. It’s true that the Fed can create currency out of thin air, and it’s true that they lend money to banks. Let’s talk about lending first.
National central banks serve a role as the lender of last resort. That is, when small banks need cash, they borrow money from big banks. When those banks need cash, they borrow money from even bigger ones. And when those guys need cash, and they can’t borrow it from each other, they borrow it from the Federal Reserve. Doing this ensures that currency will always be available when it’s in demand.
The Fed lends cash to large banks (well, technically any bank) through the “discount window” at a certain interest rate. But in general, the Fed doesn’t want banks borrowing a ton of money from the discount window, which is why they set the interest rate there slightly higher than the big important one, the target federal funds rate.
It’s called a target because the Fed does not actually lend any money at this rate. Rather, they attempt to manipulate the currency market in such a way that the major banks will lend money to each other at this rate. (This generally means big banks lending money to smaller banks, but they also lend to peers from time to time.)
Complicating matters, this money being lent between banks is not just any money, but part of the banks’ reserve balances. Reserve balances are a small percentage of the banks’ assets which they are required to deposit into their Federal Reserve accounts. At the end of the day, if you have more reserve cash in your account than is required, you can lend some of it to a bank with a shortfall. (If a bank is unable to meet their reserve requirements, they will get in big trouble.) Since all of this takes place within the Federal Reserve (briefly transferring cash from one reserve account to another) it’s very efficient and convenient.
Now the interest rate at which this money is lent between banks is negotiated between the borrower and lender. But the Fed wants them to lend at the target rate that they have set. So here’s how they make that happen:
If the Fed wants to increase the money supply, they will buy securities (almost always US Treasury bonds) from the banks. The Fed pays for these securities with dollars, which are deposited in the selling banks’ Federal Reserve accounts. This means the banks will have a bigger cushion of cash in their reserve accounts, which means they will be willing to lend to one another at a lower rate.
If the Fed wants to decrease the money supply, they will tell the banks to buy back the securities. (The banks have to do this if instructed, but 99% of the time they will comply willingly.) The banks pay for the securities out of their reserve accounts. This means they have less cash in their reserves, which means they may want to lend to one another at a higher rate, or may cause them to have to borrow. In either case, the demand for inter-bank lending goes up, and so interest rates increase.
The Fed keeps doing this (forcing the banks to buy or sell securities) until the actual federal funds rate negotiated by banks lending to one another matches the target rate that they want.
Right.
The main purpose of all of this is to prevent booms and panics in the currency markets, and maintain a generally stable economy with a reasonable level of inflation.
Prior to central banking in the United States, currency panics were common, because the supply of currency was finite. If the economy was booming and lots of currency was needed, you’d get massive inflation. Then the ensuing panic caused by quickly-devaluing currency would cause a bust and deflationary cycle. The gold standard exacerbated these problems as well. Now, the Federal Reserve has tools so they can increase the currency supply when demand for currency is high, to keep inflation under control. When things heat up too much, they can decrease the currency supply in a controlled fashion, causing interest rates to rise, which slows down borrowing and lending, hopefully averting a massive bubble.
It doesn’t always work, and is an inexact science. But it works a lot better than what we had before.
It’s important to distinguish between short-term and long-term interest rates. At one extreme much money is lent overnight to collect a single day’s worth of interest; at the other extreme the U.S. Treasury issues 30-year bonds. The FRB controls the short-term interest rates; long-term rates are largely determined by the market.
The difference between long-term and short-term rates is an indicator of market sentiment about the future. A difference of 2% is typical; a smaller difference would imply recession worry; a larger difference implies inflation worry. Recently when Yellen suggested she would keep the short-term rate low, the long-term rate rose.
Very low interest rates are abnormal; higher rates would be a healthy sign. But you don’t achieve that health by raising rates; the higher rates would be an effect of economic health, not a cause.
The other important point is that the Dollar is traded internationally. If the US economy is perceived (it’s perception that counts here rather than fact) to be weak, those dastardly foreigners will sell the Dollars that they hold and buy Euros, Renminbi or Mexican Pesetas instead.
This has two effects: The international value of the Dollar goes down, so US businesses have to pay more for imports (European holidays get expensive) and other countries can buy American goods more cheaply, which is good for exporters. The converse is also true.
A central bank tries to balance the economy to keep inflation down, but not too far down, and to stop the value of their currency from rising too far, making exports too expensive, or too low, sucking in more imports. Interest rates are the main mechanism for achieving this.
After Brexit, the value of the GBP has plummeted because investors are concerned about the medium term prospects. This, in the short term at least, is good for our economy, because exports are booming ( a good time for you to buy a Landrover or a Jaguar) and people are looking more to domestic manufacturers rather than imports.
The reason people think of low interest as being a way to prop up the stock market is that the stock market is competing for money with other investments. The bond market is the main competition for the stock market. When interest rates are high the bond market is a better investment and when interest rates are low the bond market is a worse investment.
So the theory is by keeping interest rates low the Fed is depressing the bond market and propping up the stock market. The hole in this theory is that as already has been pointed out, except for very short term rates, the Fed does not control interest rates, the market controls interest rates.
I might qualify this by saying “usually,” and that further discussion might be better suited for GD. I think plenty of people would argue that the Fed worsened the Great Depression by holding the money supply very tightly at the outset, for instance. Also, of course, Alan Greenspan was criticized from various quarters (generally but not entirely from the right) for allegedly having been too loose in monetary policy and allowing asset bubbles to develop in advance of both the tech crash at the turn of the century and the larger 2008 recession, making both of those events worse than they otherwise would have been; i.e., similar grounds to the arguments that Yellen is hearing now.
What are the interest rates in other countries? If there is a difference, wouldn’t foreign news be pointing this out?
Check it out…
BBC
AP WORLD
BLOOMBERG
BUSINESS WIRE
DEUTSCHE PRESSE-AGENTUR
EFE
INDO-ASIAN NEWS SERVICE
INTERFAX
ISLAMIC REPUBLIC WIRE
ITAR-TASS
KYODO
PRAVDA
PRESS ASSOCIATION
PRESS TRUST INDIA
XINHUA
YONHAP
A most informative, sensible and enlightening post, Friedo. The actions of most Central Banks seem to be purposely opaque, but you seem to have distilled what is a mass of guesswork online - or you actually understand them better than most.
