The Meaning of the Interest Rate Announcement

In our current environment, and against the warning of eminent free market economists in the Austrian tradition, the interest rates in the global economy are highly manipulated as a goal of monetary policy. Specifically, the interest rates are forced downward in an attempt to “stimulate the economy” and increase demand. Since late 2008, the Federal Funds rate has been pushed down to historically record lows:


And yesterday, Janet Yellen, for the first time since 2006, announced that the Fed was going to move up its target range for the federal funds rate.  What does all this mean?

First, the federal funds rate is the rate at which the banks borrow from each other whenever one bank needs some more liquid assets on a short term basis. It is from this rate that most other rates in the economy are set. This rate is generally the lowest rate in the economy. The banks can borrow at this rate and then lend out at a slightly higher rate, and take the difference (called “the spread”) as a profit.  Therefore, the Fed works to influence this rate, with the understanding that the lower this rate can be pushed, the more room there is for subsequent rates to fall as well (after all, banks have to compete with each other to make loans and so the incentive is there to give borrowers a better price).

Most people express what happened yesterday as “the Fed is raising rates.” Technically, there is more to it than that. The Fed doesn’t just go in and peg a specific rate; rather, it uses its various “tools” to influence the market and therein aim for a target range. Previously, the target range for the Fed funds rate was between 0% and .25%.  What the Fed did was move the target range up “25 basis points (bps)” to between .25% and .50%. How is it going to actually accomplish this goal? After all, it’s easy to talk about it on paper and in a meeting, but what are the mechanics of actually doing it?

First, we need to understand how the Federal Reserve creates money. There are several different ways, but the one that is relevant for us is “Open Market Operations” (OMO). Whenever the Fed creates money via OMO it first has to buy something. It can buy whatever it wants. It can buy shares of a company, it can buy your car. Usually, the Federal Reserve buys US debt (treasuries) and things like mortgage backed securities. Let’s take the treasury purchases as an example. The Fed announces once a week that it is going “into the market” to purchase Treasury Bills. It does not purchase the debt directly from the US Treasury. This is because the US Treasury does not generally sell to any person or institution except a set of privileged banks known as the “Primary Dealers” (here is a list of the primary dealers). These priviledged banks buy treasuries and then sell them to other banks, or, in our example, to the Fed itself. The Fed basically writes a check on itself and money is transferred to the primary dealer’s account and the treasuries are added to the Fed’s “balance sheet.” Whenever the Fed “writes a check on itself” it gets the money by creating it into existence for the first time. These days, the creation of money is simply a digital entry in the computer.

As the money supply increases, the interest rate (the cost of borrowing money) is lowered, starting with the Fed Funds rate, as a reflection of supply and demand. This is how the Fed influences the interest rates: increasing the money supply.

Now then, with all these asset purchases in the economy (and the Fed also buys mortgage backed securities and other things, not just treasuries), via creating more money, the interest rate eventually plummets to zero. But to prevent all these banks from loaning the money into the economy, which would surely cause mass price inflation, the Fed has a tool: IOER (interest on excess reserves). Basically, the Fed entices banks to store all this new money at the Fed. The Fed mandates that each bank have a certain percentage of its loans “backed up” by reserves. In the preferred Austrian endorsed system, there would be 100% reserves; but alas, in our current system the “reserve requirement” is 10%. Anything above the 10% is considered “excess reserves.”  And under IOER, the Fed pays interest on these reserves to discourage the mass lending of all the new money at zero percent interest. Until yesterday, the IOER was .25%. Which means that really the incentive was to keep excess reserves at the Fed instead of in the market where the Fed funds rate target range was between 0% and .25%.

But now that the Fed Funds target range has increased by 25 bps (.25%), they can use the IOER tool by raising it up the same amount so as to provide incentive for banks to either hold reserves at the Fed and get a higher guaranteed rate of return than before or they can still loan out that money to other banks. But if they are going to loan out that money to other banks, they will want to loan it at a better price than they could get by holding their reserves at the Fed. In this way, the Fed Funds rate can trickle up.

See Paul-Martin Foss here for how the Fed prepared the IOER several months ago to be used to encourage the Fed Funds rate increase.

The second tool that the Fed can use to increase the Fed Funds rate is called a “reverse repurchase agreement” (also known as a “reverse repo”). Very basically and to save space, the reverse repo allows the Fed to trade it’s bonds to a bank in exchange for money. Then, usually the next day, the Fed will buy back its bonds for more money than the first trade. It’s a very short term move that can incentivize banks to trade with the Fed instead of loaning the money out in the market. So now that the Fed has increased its Fed Funds target rate, they have the ability to offer a better interest rate on their reverse repos. And in fact, the Fed announced that it was prepared to offer up reverse repos to the tune of $2 trillion!

All this is to show how the Fed is going to tinker with the Fed Funds rate. What we realize here is several things: First, contrary to all the noise in the financial media, we aren’t entering in an era of monetary tightening. The Fed is still increasing the money supply. The Fed is still entering the market and buying debt as it creates new money on a weekly basis. The Fed is still dangerously inflating the money supply under the guise of “stimulating the economy.”  Second, all the clamor about a great rise in interest rates is overstated in the sense that, compared to historical interest rate level, we are still down at record lows (h/t Ryan McMaken for the graph:


Lastly, we must understand that the Fed is still manipulating interest rates and artificially suppressing them below their natural market level. Interest rates, like all prices in the economy, should be determined by the market, not the central bank. And yet, the Fed still considers itself as having adequate knowledge to know where to target the interest rate. This is what FA Hayek called “the pretense of knowledge.” The interest rate needs to be set free from monetary policy; it needs to be unleashed from the Fed’s shackles so that it may once again serve its market purpose of helping to efficiently allocate scarce capital to its most needed end.

Today isn’t a day for cheering a sane monetary policy. It is a mere tinkering with the dynamite.

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