THE BASIS POINT

Is the Federal Reserve no Longer in Control of Interest Rates?

 

This week the FOMC (Federal Open Market Committee) met and held the Fed Funds range where it was at 0-25 bps. Increasing Fed Funds could have seriously damaged the EU and emerging nations. Increases in rates here would likely have sent investors to dollar denominated assets hurting many other nations.

The problem is that the Fed no longer has control over the short-term rates. Why? Think of this like a casino. The Casino a lot more money than any of the players. Once a player’s bank reaches zero he is out of the game. So one by one the players go broke. The analog of the bankroll of a casino gambler is a bank’s Excess Reserves. Excess Reserves are funds owned by a bank in excess of required reserves but parked at the Fed each day. In August 2008 the total amount of excess reserves of all banks held at the Fed was $1.875 billion. The amount of excess reserves now held is $2.5 trillion. Excess reserves are 1,300 times what they were before the Great Recession. This gigantic increase in Excess Reserves was created entirely by the Fed through QE. The result is that the Fed has surrendered control over short-term rates.

Fed Open Market operations are now like the casino where the players, on average, have bankrolls 1,300 times what they had in 2008. The house’s edge is gone.

The Fed has tried a new tactic to set a floor on the Fed Funds rate. This policy was to pay interest of 25 bps on the excess reserves parked at the Fed.

 Open Market Activity at present is focused on keeping the 6 month Treasury at a yield of about 0.25%. It is likely that if the Fed increases the Fed Funds target they will try to maintain a 6 month yield at the top end of the Fed Funds target range.

For folks in the mortgage business the question is “what will happen to mortgage rates?” Mortgage rates tend to move in step with the 10-year Treasury. A change in Fed Funds target may have little or no effect on the 10-year or mortgage rates.

Fed Funds deals only with banks which are Fed members. But there is presently a lot of money in non-bank entities: hedge funds, S&L’s, and the GSE’s. The Fed attempts to control their rate policies with what are called Reverse Repos. Reverse Repos do with non-bank entities what Fed Funds does for banks. The Fed has put a lot into expanding its reverse repo facility. This serves as a reminder that there is a lot of money in non-bank entities.

One potential problem I see is this: if the Fed increases the interest paid on excess reserves it could generate backlash from politicians. The Fed paid $5.5 billion to banks last year for interest on excess reserves. If politicians make this a political issue by asking “why are taxpayers giving money to banks” the independent role of the Federal Reserve could be undermined by politicians. That is the worst possible outcome.

The economy at present resembles a stuck bolt. We tried the wrench – zero interest rates. We hit the wrench with a hammer – interest on excess reserves. We put a breaker bar on the wrench and stood on it – QE but the bolt remains stuck. To be clear I regard 2.0% GDP growth as “stuck.” Will increasing interest rates on excess reserves be the WD-40 which gets the economy growing again? I have no idea and frankly I don’t believe that anyone else does.

At present Fed policy is perhaps best summarized by the words on the back of paper currency “In God We trust.”

 

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