The Fed determines the base rate - or the floor. The actual interest rate a particular person pays on a particular loan depends on - among other things - with the risk associated with the loan. A person with bad credit might pay more, for example. A person who shops around might pay less.
Hold on now… are you truly unclear on the difference between the rate on your car loan and federal funds rate?
I’m really not trying to be rude. You’ve posted very detailed arguments on a variety of complex monetary issues, for which I tip my hat on your diligence. But it has just occurred to me that you may not be able to describe the difference between, say, the discount rate and the prime rate without looking it up. This just comes as a great surprise to me, for which I genuinely do not mean to offend.
If there is anything we have learned in the past few years, it’s that the Fed would have additional tools. They could, like you say, lower rates below zero. They could do what they did the past several years with quantitative easing.
Yes.
So you do grok that even if the federal funds rate were nearly–or actually–zero, you still would not get an interest-free auto loan, right?
The Fed does not control interest rates. Interest rates are set by the market. The Fed typically uses one type of interest rate to control the money supply. This confuses the press who report that the Fed is changing interest rates when what they are doing is controlling the money supply. Interest rates have to take in to account inflation so they move when inflation does, but the inflation rate is just the floor for interest rates not what determines them.
IMO, the natural rate of interest for most of the developed world has fallen and thus central banks can not just rely on the one interest rate to control the money supply. This has freaked alot of central bankers out and they want to go back to using that interest rate. In order to do so they have raise the interest rate so they can use it again in the future.
Another factor is that the central bankers are fighting the last war. The inflation of the seventies scarred alot of economists who thought they had macroeconomics figured out. This means that they are always seeing inflation under every bed, even though there is no reason to think it is going to be a problem for the foreseeable future.
I think was issue unaddressed is that despite low interest rates, individuals (I don’t know about businesses) can still not borrow money due to the FICO requirements of 640-680 many banks are using. My question is if banks are borrowing money, what are they using it for or who are they lending to?
“You are cruising along at night, with street lights as far as the eye can see. But there are no cars around, to keep the analogy from getting over-heated. Even under such circumstances, the idea that there’s a fixed natural rate of pedal pressure is idiotic.”
We will know once inflation starts accelerating. It’s between 2 and 6%. But honestly, you want to look at a broader range of measures to determine the risks of the economy overheating.
Latest BLS release: http://www.bls.gov/news.release/cpi.nr0.htm
Look at CPI minus food and energy, last column. It’s a 1 year figure. Headline inflation is at 0.2%, but that gets distorted by transient fluctuations in food and energy. A few years ago it was above 2%, but I wasn’t calling for tightening.
Core inflation has been creeping up over the past year, but is still nothing to worry about. As it happens, the Fed likes to target the core personal consumption deflator, but that data isn’t as timely. In the recent past it has been lower than core CPI.
XT: Thanks for the links. I hope to take a look at the Fed hawk case when I get a chance. I suspect that the Fed won’t be moving in September though, as it might exacerbate financial volatility, which they claim is their concern.
Can someone explain why this happens:
Let’s say there’s great news in the monthly jobs report. Say it was triple the expectations for the number of jobs created. Great news, right? Stocks should go up, right? NO! What you hear is “Markets were sharply down today because the improving economy raised fears that the fed will raise interest rates.”
What the hay? Instead of rejoicing that more people working means more money being spent and healthy sales, what the investors are saying is “OHMYGOD! INTEREST RATES MAY GO UP!” It seems to me that stocks going down because of good news is nuts and that investors should be happy that increased demand will cause expansion and more corporate borrowing. So why do investors do this?
I’ll explain. I simplify a little.
The intrinsic value of a stock is the value of the flow of dividends moving forwards. Dividends go up when profits go up (with a lag). (Oh, and I set aside stocks that don’t pay dividends: that’s a tangent.)
Say a good jobs report comes out. It implies more demand for goods and services and higher revenue for corporations. Yay! It also implies the labor market may be tightening and workers may be in a position to secure higher wages. Boo! (Or rather, yay for those getting their income from labor, boo for the value of the stock market. Tangent: the importance of the stock market is vastly overstated.). It also implies that the Fed will raise rates and bonds/bank accounts will become relatively more attractive than a stream of dividends. Boo!
The mistake is placing more importance on the Dow Jones Industrial Average than it deserves.
If you think something is going down tomorrow the time to sell it is today, that is why news about the future immediately affects stock prices.
Stocks are not the only investment. People can buy bonds as well. Bonds are safer but do not pay as well. When the Fed hikes the interest rate that raises the floor for bonds so bonds become a little better investment. This sucks some money out of the stock market which deflates it. Since investors know this even ones who don’t go into bonds do it.
Secondly, if the rate hike is unexpected it means that in the future the rate of growth would not be as high as under a lower rate. That affects business in the future which affects stock prices today.
Most unemployment reports are not a tripling of new jobs but small changes that may or may not signal a change in Fed policy. If the news really did mean a healthier economy the stock market would go up, but if it is just a small change and signals a tighter policy on the way it probably goes down.
There’s more here than I have time to respond to right now, but I’ll try to respond to some of it.
Interest is just money changing hands. If some people getting more interest, that just means other people are paying more. There’s more to it than that, because low interest rates encourage people to open businesses and buy homes and cars. But getting interest is just the flip side of paying it.
Not much to say here, because I don’t know much about defined benefit pension plans. But I will say that no one is entitled to risk-free investments, or “adequate” returns.
This part is just flat-out wrong. The Fed has said over and over that it intends to increase interest rates.
Again, this part is flat-out wrong. Oil prices are currently around $40/barrel, which is the lowest they’ve been in years.
This is a ridiculous argument - if the point is that increasing productivity per worker is harmful. Increasing productivity is the engine of real economic growth.
And implication that there’s only so much work to be done is equally ridiculous. So long as people want more and better there will always be more work to be done. Hell, we don’t even have sex robots yet!
“Holding interest rates below their natural level” is gibberish. There’s no natural level of interest rates anymore than there’s a “natural level” of creamer in coffee. And the Fed doesn’t hold them down. It creates floor, not a ceiling.
<snip>
Getting interest is the difference between a warm glow watching your savings grow and that chilling effect when you see it evaporating or being chipped away by fees. The old rule of thumb was to have one to three years of savings in an account, in case you lost your job. Only savings beyond that cushion was put into investments.
Not completely. The 3 month treasury rate hovered at low levels during the Great Depression for a while. From Apr 1934- Feb 1937 it averaged at 0.18 percent. Then the Fed tightened, which was a disaster. But from Nov 1937 to Oct 1941 it averaged .06% or 6 basis points. From Jan 2009 to now the rate has been .09 percent. Not too different.
Inflation tendencies aren’t really growing markedly. We had headline inflation between 4 and 5 percent during the late 1980s and early 1990s and there weren’t many complaints. Now inflation is below 2%: that’s too low in my view.
Yes, economists and the Fed typically set aside food and energy when calculating a price index to work out whether the economy is overheating. Another method is to look at price changes in the median price - Cleveland’s Fed constructs an index like that. The thinking is that those series bounce around so much that they are a poor guide to underlying of future inflation.
Though I’m overstating things a little. Forecasters monitor a wide range of series. Core inflation (i.e. inflation less food and energy) is a big one though.
Heh. I’ll quote the first sentence: “Most economists reading the title of this article probably think I am an idiot.” 
More seriously, his whole argument hinges on the following: [INDENT]So how is it possible to raise interest rates without tightening monetary policy? The answer is surprisingly simple – raise inflationary expectations. …
The Fed can raise inflationary expectations just by saying that it intends to allow inflation to rise. [/INDENT] Ok, so Bruce Bartlett wants lower real rates. I want lower real rates. The Fed wants higher real rates, so this article isn’t topical.
I opine that the expectations claim is untested and if you buy it then Hellestal can explain why nominal GDP targeting is superior to inflation rate targeting. (I’m too lazy to reconstruct and evaluate the arguments now - they may or may not be conclusive).
Moving on to Fortune (aka People’s Magazine for Executives). It’s a different argument: it stokes fears of asset bubbles. I find such arguments strange. The Fed’s job is to pursue a twin mandate of stable consumer prices and full employment. I don’t think a third mandate of avoiding asset bubbles is legitimate, except insofar as it affects the other 2. And if you’re worried about asset bubbles, why not put curbs on margin lending first?
The Fed monitors the credit environment. During good times, they worry if the banks are lending too freely. I’m not sure what you mean by who are they lending the money to. I see that this report from a year ago suggests they had eased lending standards for various types of loans.
Bottom line answer to the OP:
The people on the FOMC are accustomed to looking at the world through an interest-rate filter. They are uncomfortable with zero because it doesn’t fit their training and previous experience. They want to return to the world they’re more comfortable with.
The problem is that there are two different ways to get rates higher. The good way would be more accommodating monetary policy, which would encourage more nominal spending, would should naturally lead to higher rates as a response to more spending in the economy. The bad way is to contract policy using higher rates. That would contract the economy, reduce spending, and be totally and stupidly counterproductive, because rates would naturally fall in that situation. As previously mentioned in this thread, more than one central bank in Europe has tried to prematurely raise rates with a contractionary policy in an effort to return to normalcy, only to have that choice catastrophically backfire.
The good way to do this would be for rates to rise naturally because the economy has more spending, and the bad way to do this would be to raise rates and force less spending in the economy with a contractionary policy.
You left out the very, very important subtitle:
7 Reasons the Fed Should Raise Interest Rates…
…and Still Keep Easy Money Flowing through the Economy
Bruce Bartlett is saying that interest rates should rise without a contraction in policy. I agree with him (although I don’t agree with all of his sub-arguments).
I don’t personally find that to be a similar article. Bartlett’s article is good, even if I don’t agree with his argument. This one is a disaster.
I mean: “For one thing, the Fed can’t really influence wage levels.” That’s like saying that the sun doesn’t make the earth warmer, and for evidence, he cites the arctic circle which gets six months constant sun in the summer, and look how cold it is! The argument is so wrong-headed it’s just depressing. Bottom line is that the Fed strongly influences total nominal spending in the economy, and total spending is one of the most important components, if not the number one most important component, in determining changes in wages. He’s looking through an interest-rate filter and getting everything totally and completely backwards.
If there were no lending at current rates, then we wouldn’t know the current rate. You can look at changes daily.
Not every institution with a Federal Reserve account is being paid interest on their “excess reserves”. Only depository institutions with required reserves are being paid money on excess reserves. Any other institutions with extra cash, who are not being paid a quarter point on their extra cash, might still want to lend that cash through federal funds. They are more than willing to accept a rate of less than a quarter point, which is better than what they can earn otherwise (zero percent).
More than that, federal funds is only through the regulated US system. Interbank lending is also done internationally, and of course, many of those institutions around the world who take dollar deposits don’t actually have accounts at the Federal Reserve. They don’t earn a magic quarter point, either, so they’re willing to lend at less than that amount on the international interbank market. More than that, any individual banking institution might be in serious need of short-term liquidity regardless of price – they might have cash flow problems – and so borrow from another bank. But if there’s risk, that borrowing won’t be through the uncollateralized federal funds market. Other banks will demand collateral, and the rate they charge will be in excess of a quarter point and will not show up in the fed funds data.
I’m certain to be leaving even more counterexamples. Banks lend to each other all the time, in all sorts of ways, and you can’t just compare federal funds to IOR and believe that explains away all interbank lending. The world is more complicated than that.
The good news is that judging from past central bank mistakes (Japan prematurely lifting rates in the 1990s, the ECB doing it during the Great Recession, the Fed erring in 1937), they tend to enter their comfort zone in the 0.50 or at the very very most 0.75% territory. So their errors, while unfortunate, tend to be self-limiting.
Twelve Steppers
The Fed is very much aware of 1937 though. But it’s been so very long since they have take the punch bowl away: they must be experiencing withdrawal symptoms now. At any rate I doubt that we’ll see a rate increase next month and I’m guessing that they won’t in December either. March 2016 is more likely IMHO.
That may be too early. Higher core inflation would permit greater real wage cuts in the face of a downturn when businesses need them most. It would permit lower real interest rates during recession, spurring investment. You could arguably get a similar effect with nominal GDP level targeting, though the implementation is awkward since GDP figures are subject to revision over extended periods of time. Doable I think, but there are some details to address. The framework would involve the sorts of growth cone charts used for the money supply during the early 1990s.
Traditionally, the U.S. has relied on commercial banks to provide liquidity (money). The problem with relying on commercial banks is that they both create and amplify boom/bust cycles in the economy. So long as the U.S. continues to rely on commercial banks, the recession/recovery/recession pattern will continue.
The Fed has taken an unprecedented step in creating $3 trillion in government-backed money (as opposed to commercial bank money). It’s an experiment that has worked. Unemployment has dropped from about 10% to about 5.3%. Inflation has remained historically low - 0.3% right now. The deficit has fallen from $1.4 trillion to less than $0.5 trillion. Meanwhile, other developed countries continue to struggle. Unemployment in Europe averages about 10%, and is as high as 20-25% in some countries.
What’s needed is for the Fed to continue to buy Treasuries, for the Treasury to continue to issue them, and for the U.S. government to spend the money into the economy - and it needs to be an ongoing program. As long as the U.S. economy continues to grow, it needs more money. And it needs more money to continue growing.
If you want to use the economy-as-a-vehicle analogy: you can’t expect a vehicle to go unless it has gas, and the bigger the vehicle, the more gas it needs.
The Fed does not need to lower interest rates to prevent a recession. It merely needs to buy Treasuries, while the U.S. government continues to spend the money.
That’s a fair -er- misunderstanding. You get that sense from the financial media.
But pause for a second. Raising rates slows the economy. Are you saying that we should slow the economy, deepen the upcoming recession, so that we can stimulate the economy later? That would be like hitting your hand with a hammer so you can stop hitting your hand later. If we want to increase the effectiveness of monetary policy, a higher baseline rate of inflation is the way to do so. Either that or adopt a smarter framework along the lines Hellestal advocates - which is yet untested. There’s evidence. But we haven’t tried it yet. (I would argue that it would be possible to phase such a framework in, so the risks are manageable IMHO.)
Also, while it’s true that recessions are a recurring feature of post-agricultural economies (and agricultural ones that trade in world markets) they don’t occur like clockwork. You need a shock to set them off. Historically that shock is supplied by the Fed in an attempt to head off inflation.