The Nitty-Gritty of Fed Rate Hikes

Fed, FOMC, interest rates, rate hike
Public Domain, https://commons.wikimedia.org/wiki/File:Jackscrew.gif

Fed, rate hikesFor the past two or more years the question of whether or not (and when) the Fed might “raise interest rates” has been a constant feature in the news.  With the FOMC, the Fed's rate setting body, meeting next week, this is especially true at the moment.  But no one seems to understand the nitty-gritty of just how interest rates are raised (or lowered), and very few non-economists have any knowledge of how it happens.

At times, the news reports seem to suggest that somewhere within the bowels of the New York Fed there is an interest-rate-machine, and that the monetary authorities have only to push a button, and, Voila!, interest rates will be raised.  No one asks just how much they might be increased, or what happens then, although some accounts suggest that such an action would signal an end to the stagnant economy and better times ahead.

The Fed has no interest rate machine.  To “hike rates” the Fed Open Market Committee (FOMC) must use its power to diminish the economy’s quantity of spending money through its control over the Monetary Base (MB), which is the accounted sum of the monetary obligations of the 12 Fed Banks.  This Base includes two liabilities of the Fed Banks—the stock of hand-to-hand currency and the reserve-deposits of almost all of the commercial banks.  To hike rates, the FOMC must decide to SELL government securities in the financial markets from its huge stockpile of security holdings—think ‘national debt.’  Fed Banks have accumulated these securities by previous purchases that lowered rates and increased the economy’s stock of money.  Now, however, the call is for a ‘rate hike’ so the FOMC would have to sell off some of the Fed’s securities.  It would make the sale through the offices of the Fed Bank of NY, by offering them on the financial market at attractive (low) prices relative to the annual dollar payments the securities promise their holders.

A large fraction of the sales would be to commercial banks thereby reducing their reserves, which would ordinarily force them , in turn, to reduce their lending to business firms.  However, the banks at the moment have a huge volume of excess reserves on which they get one-fourth of one percent (0.25%) interest from the Fed Banks.  These reserves are “excess” because they are not being utilized to “back” checkbook deposits that all households and businesses count (properly) as money.  If the reserves had been used to finance the investments of private business , industry and households, the economy’s accounted stock of money would be perhaps double what it is now.  But a large fraction of the Reserves has been “sterilized” by the device of this trivial interest rate paid on them.

With the FOMC selling, however, market rates might rise enough so that commercial banks would use up these sequestered reserves, and the depressing effect of a ‘rate hike’ might be avoided.  But no one knows for sure.   That’s why the officers in the Fed system are procrastinating.

Another important factor is also in the picture: the huge annual government deficit of more than a trillion dollars that must be funded every year.  A ‘rate hike’ would make these annual borrowings much more difficult for the U.S. Treasury to finance.  And if the fiscal problem becomes unstable—more deficit to finance than security markets will allow, the Fed will obey its political masters and finance the deficit by a hyper-inflation, or hyper-tax, as a burgeoning inflation simply taxes all fixed dollar wealth—bonds, dollars, life insurance values, etc.—by the rate of price level increase.

Finally, we might ask: ‘Why are rates so pervasively low.  And why haven’t previous Fed and Treasury spending policies provided a path back to a healthy economy?’

The answer is that the Fed controls the monetary system, but it does not control the real system — the production of goods, services, and capital.  The real system also has an interest rate — the real interest rate.  At the moment, the real rate is effectively zero, because its determinants — the real rate of gross private domestic investment, and the real savings to finance those investments — are near zero.  Taxes, regulations — the “Ten Thousand Commandments,” litigation, and harassment of venture capital has alienated real investment severely.  Consequently, no matter what the Fed does or does not do, real values, including real incomes, are going to remain depressed into the foreseeable future.  No amount of money and no monetary policy is going to change the government-imposed real depression.

  • Why did you ruin a perfectly good post by parroting nonsense right-wing dogma like "investment is low because of taxes and regulation?" You are too good an economist to not realize that our economic malaise is due to demand-side, not supply-side, problems. Look, I'm the first to wish for supply-side improvements like relaxing of zoning, occupational licensing, and skilled immigration restrictions. But these things are not the limiting factor for the economy right now. Investment is low because AD is slack, and investors don't see a way to make money by increasing capacity. Just look at trend NGDP growth from 1984 to 2008, and then 2008 to present, and you can see why investment is low. Increasing productivity does not help if there's no buyers to consume the increased product.

    When you substitute red tribe dog-whistling for good economics, you lose credibility with the intelligent portion of your audience.

    • Paul

      Let me guess, the "cure" for slack AD is more govt spending?

      • Tommy

        Or reducing labor supply by deporting illegals and going to a policy of net-emigration of thrid world immigrants.

        Reducing the size of the labor will reduce GDP, but it increases employment faster, resulting in higher expected life-time incomes and stimulated demand.

      • No, the cure for slack AD is better monetary policy. Level targeting of some sort would be a good start.

    • Andrew_FL

      Says the guy substituting blue tribe dog-whistling for good economics.

      If there is no point after which you stop insisting years of consistently slack demand as nominal spending grows at a steady rate, you're not an economist, you're an inflationist ideologue.

      How many years after the fact are you going to keep saying this? One gets the distinct feeling the answer is "forever."

      • What "blue tribe dog whistling"? I donated a significant amount of money to the Mercatus Center to support their Program on Monetary Policy. How do you get less blue tribe than that? The blue tribe is completely insane when it comes to microeconomics. The red tribe at least gets micro. But both tribes are out to lunch on macro.

  • W. Ferrell

    "At the moment, the real rate is effectively zero, because its determinants — the real rate of gross private domestic investment, and the real savings to finance those investments — are near zero. " I would appreciate someone making an effort to support this statement.

    And in doing so, please explain why huge borrowing demand by govt does not enter into the calculus of the real interest rate.

  • Benjamin Cole

    Great post, but…

    Sure, we all support less regulation and lower taxes. But the US economy flourished in the 1950s and 1960s with higher tax rates and terrible regulations, and Big Labor, and Big Auto, and Big Steel, and little foreign trade or immigration. The economy did great from 1982 to 2007 also. About 3% growth and 3% inflation all through that 25-year run. Awful taxes and regulations.

    The Fed cannot raise or lower long-term interest rates, at least not immediately.

    But the Fed can engage in aggressive quantitative easing. The QE would be stimulative and so far has not been inflationary. There is still tons of slack out there.

    Hey, bring on the lower taxes and regulations.

    Can we outlaw city single-family detached zoning by cities? How about de-licensing of lawyers? Kill off fuel-ethanol. Wipe out the VA. Cut defense spending in half. Go to a consumption tax and no income or capital gains taxes. Kill off the SSDA "disability" program. No more pensions for any federal employee, civilian or military.

    All of that would be wonderful, but ain't going to happen.

    So…the Fed should blow the doors wide open and pint money to the moon. Full Tilt Boogie in Fat City should be the goal, and chronic labor shortages.

    After 10 years of that, we can decide what to do next.