Why is the Fed so anxious to raise interest rates?

Great Debates
81

There is a saying, “If you must forecast, forecast often”. September is back on the table and a few are discussing October:

Calculated Risk quotes the WSJ: Calculated Risk: Sunday Night Futures
Tim Duy quotes a bunch of FOMC inflation hawks: http://economistsview.typepad.com/timduy/2015/08/hawkish-rumblings-.html

Tim Duy: Bottom Line: The Fed doesn’t want to take September off the table. Many officials had what they believed was a solid case for hiking rates at the next meeting, and they don’t want market turmoil to undermine that case. And that case is not complicated. It’s the Phillip curve combined with an estimate of full employment (an estimate of full employment that remains sticky despite the persistent downtrend in inflation). If they move in September, that’s the story they will run with. They don’t have another paradigm. Hm. Maybe Duy is politely wondering whether some of these hawks are expressing derp. That is a little unfair on my part though.

My bottom line: core inflation of 1.2% is risky: a negative shock could take us into deflationary territory. That would be less of a problem if the dose-response relationship between the economy and unconventional monetary policy were established, well understood and of sufficient magnitude. But none of this is necessarily the case. Inflation hawkishness can be irresponsible.

In addition to expectations, excess reserves are consistent with basically any interest rate. Banks may choose to keep some of their assets in the form of cash for safety considerations. Admittedly 3 month treasuries essentially only have interest rate risk.

Secondly, if excess reserves are truly just taking up space (which would be different than their role during the great depression, when banks kept them because they were nervous) exchanging them for t-bills wouldn’t be a big deal. I don’t see the problem.

Back during the 1930s the Fed perceived the skyrocketing excess reserves as a concern: they thought they might lose control of monetary policy. When they bought some of them back, they discovered that rates increased: the excess reserves were actually playing a role.

Off topic but supply side factors loom in the background of discussions like this. One wonders whether great investment opportunities have dried up, or rather that they have been displaced by stock buybacks and other methods of juicing executive pay. No doubt that a heated economy produces hotter money though, to use your metaphor.

82

Fair point.

83

Hi MfM, I wanted to ask you about the sentence I bolded.

I’ve always been under the impression that the Fed’s control over interest rates was a function of its ability to control excess reserves. Basically, banks need reserves: mainly for regulatory reasons, but for operational reasons as well. However (until recently) excess reserves paid nothing. A profit-seeking bank, therefore, would try to keep excess reserves as low as possible. If a bank had excess reserves, at the end of the day, they’d lend them out to other banks. The rate they got would be a competitive market rate. That rate, in turn was called the federal funds rate.

If my understanding is right - and please correct me if I’m wrong- how can the fed change interest rates - or more specifically, the federal funds rate - without massively reducing excess reserves?

84

It has everything to do with the price of capital. By printing money, the Fed is making the cost of capital essentially zero-that means that even if you have a huge 401 K, you cannot live off it (except by depleting it).

85

If your 401K has dividend producing stocks, you can live off corporate profitability, not interest rates. Companies with lots of cash, cheap access to money, and few investment opportunities are sometimes pressured by stockholders to share it with them in the form of dividends.
Selling in a rising market does deplete your investment in a sense, but it also changes paper gains to real ones, locking them in. The 4% (or whatever) rule for selling assets is kind of like dollar cost averaging in reverse.

86

OK, that was my mistake, confusing interest and dividends.

But seriously, how many retirees make enough off of interest to live on?

87

Excess reserves tend to expand in times of financial stress, since while they pay a low rate of return, they are also safe. Three month treasury bills currently range between 0.06 and 0.12 percent, while excess reserves pay 0.25. As long as the fed continues to pay more than the 3 month treasury rate, there will be excess reserves. Heck I assume they are a form of Tier I capital now.

The Feds plans are here: [INDENT]Specifically, when economic conditions warrant the commencement of policy firming, the Federal Reserve intends to set the IOER rate equal to the top of the target range for the federal funds rate. [/INDENT] IOER: Interest rate On Excess Reserves.

Since the 3 month T-Bill rate is typically somewhat below the Fed Funds rate (IIRC), I guess we’ll be seeing excess reserves balances for some time. That said the Fed can do what it wants, when it wants: [INDENT] The Board will continue to evaluate the appropriate settings of the interest rates on reserve balances in light of evolving market conditions and will make adjustments as needed. [/INDENT] So how does conventional Fed policy work? They buy and sell bonds so as to target the interbank overnight rate (aka the Fed funds rate). Because long term rates are related to expected short term rates, this affects the entire spectrum of maturities.

Article on interest payments on excess reserves, FWIW. The characterize the payment of interest on excess reserves as (among other things) providing an exit strategy after they remove monetary policy stimulus. Why did the Federal Reserve start paying interest on reserve balances held on deposit at the Fed? Does the Fed pay interest on required reserves, excess reserves, or both? What interest rate does the Fed pay? - San Francisco Fed

The role of required reserves in the banking system evolved a lot in the early 1990s. I should admit to a certain fuzziness on the details on this point.

foolsguinea: “But seriously, how many retirees make enough off of interest to live on?”

Beats me. Presumably most spend down their principle over time. Quite a few are over-optimistic and end up relying more on social security than they anticipate. Regardless of financial conditions.

88

Tim Duy is the best public Fed Watcher I know of, so most of his blog addresses what he thinks the Fed will do. But he does offer his opinions on what they ought to do from time to time. On Monday he argued that, the timing of the first rate hike will reveal a great deal about how hawkish the Fed is. The Fed doesn’t want to leave that impression: they have said repeatedly that even after they raise rates, policy will remain extraordinarily accomodative.

Duy basically says, “Really? Tell that to the residents of Japan, Europe and Sweden, each of whom experienced an extended downturn after their central bankers jumped the gun. The Fed faces a dual mandate. The labor market is tightening. Core inflation is drifting away from their target. If they raise rates now they are saying that they don’t care about the latter. That’s pretty hawkish and will shape rate expectations moving forwards. As it is, the odds of a September increase are pegged at only 50%. The date of the first liftoff matters.”

(Duy appears to have a typo: he says that core CPI is drifting away from the target. But it’s not. Core PCE -the one the Fed says they care about- is the one drifting away. The graph though is labeled correctly.)

Closing remarks by Tim Duy: [INDENT]Again, Fischer seems to fear the opposite risk more. Via the New York Times:

[INDENT][INDENT] And Mr. Fischer emphasized that Fed officials could not afford to wait until all of their questions were answered and all of their doubts resolved. “When the case is overwhelming,” he said, “if you wait that long, then you’ve waited too long.”[/INDENT]

I am not looking for an overwhelming case, just inflation that is trending toward target instead of away. Yet even that is apparently too much for Fischer as unemployment bears down on their estimate of the full employment.

You can take the central banker out of the 1970’s, but you can’t take the 1970’s out of the central banker.

Bottom Line: I am coming around to the belief that the timing of the first rate hike is more important than Fed officials would like us to believe. The lack of consensus regarding the timing of the first hike tells me that we don’t fully understand the Fed’s reaction function and, importantly, their confidence in their estimates of the natural rate of unemployment. The timing of the first hike will thus define that reaction function and thus send an important signal about the Fed’s overall policy intentions. [/INDENT][/INDENT] Chart 3 from Brad DeLong’s post shows why reliance on the unemployment rate only is particularly troublesome at this juncture. A September increase should be off the table. But it is not.

89

What’s important to remember is that retired people (people who don’t work) are living off of the production of goods and services of people who do work. Money is a way of distributing goods and services, but money itself produces nothing. As a simple thought experiment, suppose everybody was the same age, and everybody saved a billion dollars for retirement. The fact that everybody had saved a billion dollars would be meaningless, if there was nobody to do the work: make wheelchairs, or medicines, or put groceries on the shelves. All those billions of dollars would be worthless. The level of wealth in society is determined not by the number of dollars, but by the number of people working, and their productivity. That’s one of the reasons productivity is so important: the more productive each worker is, the more non-workers he or she can support.

For society as a whole, rather than for a particular individual, the ability of some people to retire is a function of the number of people still working, their productivity, and their willingness to give up some of what they produce for the sake redistributing it to retirees, or others who aren’t working.

But to answer your question, low interest rates are generally good for business. They allow business to expand more quickly, and help new businesses by allowing them to pay off loans, while still turning a profit. So increasing interest rates would hurt people who rely on dividends, because when costs of doing business go up (like the cost of servicing debt) the ability of businesses to pay dividends declines.

Higher interest rates also hurt employment, because businesses that would otherwise expand might choose not to expand, if the cost of obtaining financing goes up. That means fewer jobs. And people without jobs, of course, don’t contribute anything to Social Security. They may also find themselves unable to make payments on student loans, mortgages, credit cards, or other interest-bearing debt. Furthermore, they may wind up collecting unemployment, or other benefits, which in turn mean those who are still working must pay more to support those who aren’t.

90

My ignorant, tremendously oversimplified understanding is that you raise interest rates in an economic boom and cut interest rates in a recession. I’m guessing the idea is that there’s economic growth now?

91

There isn’t enough inflation for their claimed target though. If your target is 2%, and you’ve been down below 1%, you don’t put on the brakes at 1.5%. Let it float (not spike) above 2% and then pull back. Or at least that’s the argument from those worried about a contraction.

92

Not bad Velocity.

The twist is that the Fed Funds rate is now at about 1/10 of a percentage point. It basically can’t go any lower. So if the economy weakens -say due to the premature tightening of policy- the Fed’s ability to stimulate the economy is limited. So we need to get it right the first time - unlike Japan which tightened too soon during the 1990s, the European Central Bank which tightened too soon a couple of years ago, ditto with the Swedish Central Bank and the Fed did during ~1937.

Also, I would argue, we need to prevent something like this from happening again. The stimulatory effects of conventional policy are tied to the inflation-adjusted interest rate. With a higher base rate of inflation -say the one we had during the early 1990s- monetary policy becomes more effective. The problem is that central bankers don’t like to lose their reputation for inflation fighting. So it’s tricky.

Incidentally, the Fed is aware of all of the preceding. Methinks tightening is a bad idea on their own terms – though the markets disagree with me. The markets think that the odds of a September tightening are about 50%. I’d take that bet: I forecast that the Fed will keep rates the same during the next meeting: I am even-money confident.
(I have ignored unconventional monetary policy in this post: even when the Fed Funds interest rate is at the lower bound, the Fed can shape expectations and launch another QE program.)

93

There’s no reason to ignore QE.

But in the little bit of research I did, it looks like the only way the Fed can raise interest rates is to either raise the interest it’s paying on excess reserves, or to start doing repos with financial institutions that don’t qualify for excess reserve interest. Either of those seems like it would have a limited effect.

94

You might want to take a look at this paper: Monetary Policy 101: A Primer on the Fed’s Changing Approach to Policy Implementation (PDF) http://www.federalreserve.gov/econresdata/feds/2015/files/2015047pap.pdf
From their abstract: [INDENT]For many years prior to the financial crisis, the FOMC set a target for the federal funds rate and achieved that target through small purchases and sales of securities in the open market. In the aftermath of the financial crisis, with a superabundant level of reserve balances in the banking system having been created as a result of the Federal Reserve’s large scale asset purchase programs, this approach to implementing monetary policy will no longer work. This paper provides a primer on the Fed’s implementation of monetary policy. We use the standard textbook model to illustrate why the approach used by the Federal Reserve before the financial crisis to keep the federal funds rate near the FOMC’s target will not work in current circumstances, and explain the approach that the Committee intends to use instead when it decides to begin raising short-term interest rates. [/INDENT]

95

Thank you.
I haven’t read the whole paper whole paper yet, but it seems to be saying the Fed intends to use reverse repos to try to raise interest rates. I see some problems with that, but I’ll read the paper first. Thanks again.

96

I read the paper last night. From memory:
[ul]
[li]The fed funds rate target is now a spread of 25 basis points. An increase would put us in the .25 to .50 range.[/li][li] The upper bound is set by payments on excess reserves.[/li][li] The lower bound is set with repos. [/li][li] Not all institutions that keep excess reserves at the Fed receive interest payments on them.[/li][li] So there’s arbitrage: banks lend to the Fed at the upper bound and borrow using the fed funds system. Agencies are willing to lend using the fed funds system at any rate above the lower bound. [/li][li] The Fed plans to keep their bonds, but not roll them over as they mature. So the fed funds rate won’t be set using open market operations, until their stock of reserves gets whittled away to a certain point. [/li][/ul] This process is a more than a little different than the operations were before the financial crisis. But apparently they tested the repo part of it in 2014-2015. Maybe earlier as well.

97

Fedwatcher Tim Duy goes full Marxist on us: If you ever wondered whose side the federal reserve is on. Pretty devastating actually.

Productivity has grown faster than real compensation per hour for decades now. It was not always that way. For the moment real wages are growing just as fast as productivity. So according to Richmond Federal Reserve President Jeffrey Lacker it’s ok to tighten. Productivity beats wages and proceeds go to capital: no problem, not an issue. Wages finally grow at productivity’s speed as inflation declines away from target, well I guess it’s time to tighten. Can’t let those ruffians get the upper hand, can we?

It’s really a sight to behold. I still think the Fed won’t tighten this month though. If they do they risk getting egg on their face, like the Swedes, the Japanese and the European Central Bank. The penalty for tightening too late is far smaller than the penalty for tightening too early when inflation is this low. FOMC members don’t want to be labeled inflation nutters.

98

No matter which way you slice it, it’s a horrible horrible policy.

The 25 basis points the Fed is currently paying banks for excess reserves is literally just free money for banks. Increasing it means more free money for banks. Moreover, it’s money that would be going to the US Treasury, if it wasn’t going to banks.

Reverse repos are the same thing, except they’d be going to other financial institutions, instead of banks (or in addition to banks).

I wonder how many people realize that: that the Fed is giving away billions of dollars to banks, for literally doing nothing, instead of paying it to the Treasury, where it could be used to reduce taxes or build roads?

And why? Because they want higher interest rates. Despite the fact there’s no inflation to speak of and millions of people are still unemployed.

Meanwhile, productivity keeps rising while wages and salaries remain stagnant. Which means exactly one thing: that the value of the increased productivity is going to owners - in the form of profits, interest, rent, or other unearned income - instead of workers.

According to the NY Times,

Wages have fallen among all workers, but have fallen the most among the lowest-paid, (-5.7%) and least among the highest-paid (-2.6%).

If you looked just at what the Fed was doing, without knowing what it was, you would think they were consciously trying to move as much income from the poor to the rich, as possible.

99

Interestingly, Larry Summers opposes an immediate rate increase. He was passed over for Janet Yellen when Obama appointed a new Fed chair. Both are fine economists, but Summers is more of a headbanger.
Banks face greater regulation and higher capital requirements, so I’ve wondered whether payments on excess reserves were a hidden subsidy to help them on their feet. I frankly don’t have much problem with expedient measures.

Arguably that’s barking up the wrong tree though. Increasing short term rates might require a pretty large open market operation, which could have ripple effects further down the yield curve. It seems safer and more predictable to do it this way. Yes, yes, the wind would be on the Fed’s back due to expectations. Still, I perceive legitimate worries that this could get disruptive.

Circles
However… there’s nothing stopping the Fed from combining this sandwich policy (paying 0.50% for excess reserves while issuing repos at 0.25%) with standard open market operations. Just take things slow. Except… that sets a bad precedent. The Fed wants to able to credibly commit to buying treasury securities and keeping them for a spell. That makes their unconventional QE efforts more effective, expectations wise. Sort of. It doesn’t really to the extent that a rate increase is a rate increase. So maybe the Fed is just credibly committing to focusing their attention when tightening on the shortest part of the yield curve. I’m not clear on the advantage of that. So… maybe their intent to skip open market operations and just let their bonds mature is indicative of… something. :confused:
There’s yet another case for giving the market clear signals that they think tightening is imminent, even if it doesn’t occur this month. Some bozo institution is likely to be caught flat footed, and it would be nice to be able to point to ample warnings.

100

Wonkish: Larry Summers lists 5 reasons why the Fed should not raise rates next week.

  1. Markets have already done the work of tightening. (Me: Then again, there could be a rally if the Fed takes a deep breath).

  2. Data suggests slowing. Lower employment growth. Also more comprehensive measures.

  3. C’mon inflation is low and the case for it breaking out is weak. The venerable Phillips curve is unstable (me: and always has been. Source: Dornbush and Fisher!)

  4. I’ll quote this one:

[INDENT][INDENT]Fourth, arguments of the “one and done” variety or arguments that the Fed can safely raise rates by 25 BP as long as it’s clear that there is no commitment to a series of hikes are specious. If as some suggest a 25 BP increase won’t affect the economy much at all, what is the case for an increase? And when the same people argue that 25 BP will have little impact and that it is vital to get off the zero rate floor, my head spins a bit.
[/INDENT]
Oh man, it gets better:

[INDENT]From the Vietnam War to the Euro crisis, from the Iraq war to the lessons of the Depression we surely should learn that policymakers who elevate credibility over responding to clear realities make grave errors. The best way the Fed can maintain and enhance its credibility is to support a fully employed American economy achieving its inflation target with stable financial conditions.
[/INDENT]
5. Risks are underestimated now. There’s turmoil in China. Our ability to predict negative shocks sucks. So objectively there’s a risk that we even need more stimulus now. And hey if our number doesn’t come up (and it probably won’t) no harm: inflation pressures are low. [/INDENT]

Anyway, the odds of an increase have dropped from 50 to 34%. All to the good.