I chose my title carefully. I will focus on what is possible for the U.S. central bank to achieve rather than what they might want to accomplish or may attempt to effect. I examine three possible senses in which the Federal Reserve could not raise interest rates, or would not be able to raise them to the extent they wish.
First, the Fed might face financial headwinds working against attempts to raise short-term, domestic interest rates. Second, there might be undesirable consequences to raising these interest rates that render it practically impossible to pursue higher rates. Third, it might be technically impossible to raise rates.
The major financial headwinds are the actions of other central banks. There are now more than 20 central banks in the world that have instituted negative short-term interest rates (including all of the Eurozone). The trend has been for more central banks to go negative, and for those already in negative rate territory to go deeper. In some of these countries, yields are negative out to 10 years and even beyond.
Were the Fed to attempt to hike short-term interest rates another 25 basis points, it would be moving against the tide of global central bank policies. The European Central Bank’s overnight deposit rate is -40 basis points. The Fed is paying 50 basis points on reserves, so that is a positive spread of 90 basis points. Were the Fed to raise the rate to 75 basis points, there would be a positive spread of 115 basis points.
In the near term, a Fed rate hike would attract capital flows into dollar assets. That would put upward pressure on the value of the U.S. dollar and off-setting downward pressure on short-term U.S. interest rates. It is difficult to go up when the world is headed down.
The first case transitions into the second case of undesirable consequences. A higher dollar is normally viewed as undesirable because it stimulates imports and slows U.S. exports to world markets. With U.S. economic growth hovering around a 1-percent annual rate, there is little appetite among policy makers for growth-retarding policies. So it would be practically impossible, even though conceptually possible, for Fed officials to raise interest rates. Some might translate that as politically impossible even though economically feasible.
The third case is perhaps the most interesting because it arises out of a novel factor. In the past, the Fed affected short-term interest rates by buying and selling short-term Treasury obligations. Its target was the federal funds rate, the interest rate paid by banks to borrow reserves from other banks. To raise that target rate, the Fed would sell Treasury bills (short-term Treasury debt). That would raise other short-term interest rates, and soon the fed funds rate as banks were stimulated to borrow to earn higher returns.
The problem is that the Fed no longer holds short-term assets on its balance sheet, and has not for some time. It has nothing to sell and no ability to directly impact short-term interest rates. It faces a technical problem in raising rates. That accounts for its use of interest on reserves and the reverse repo market to raise rates. In December 2015, the Fed raised the interest paid on reserves from 25 to 50 basis points. It also posted an offering rate of 25 basis points on reverse repurchase agreements. The idea was that arbitrage would increase the fed funds rate to a range of 25 to 50 basis points.
The December action had limited success. The fed funds rate did move into the target range and has recently been in a 36-40 basis-point range. In secondary markets, however, interest rates on short-term treasury bills (4 weeks) have traded down close to or even below 25 basis points. They averaged 22 basis points in June and 26 basis points in July. Additionally, the interest rates on 5- and 7-year Treasury inflation protected securities (TIPS) are negative.
There are real questions as to whether further hikes in what are administered (not market) interest rates will move market interest rates as desired. We have no experience on which to base such a forecast.
Further, banks are no longer reserve constrained. They need not borrow from each other to acquire earnings assets, but can lend or invest their excess reserves. In such a world, “announced changes in the federal funds rate therefore have no implications for economic activity, or the rate of inflation” (Jordan 2016: 382). Even if the Fed can change the fed funds rate in that situation, we must question whether it can predictably affect economic activity.
Let us return to the world in which we seem to find ourselves, namely the Fed still has some (perhaps diminished) impact on market interest rates. Fed officials confront an impossibility theorem of their own making, however. They want to hike rates but at no substantial costs. Each time they send signals to financial markets of their intent to do so, however, they create the financial turmoil they are trying to avoid. Asset prices factor in continued low interest rates, as do the many carry trades that bolster these asset prices. As already noted, foreign currency markets are sensitive to even small changes in interest rates.
That is not to say that a rise of 25 basis points by itself will upend financial markets. But, as has been signaled in past statements by Fed officials, there is a planned sequence of rate hikes. The Fed has been stalled since its first increase in December 2015. Another increase will be viewed as a resumption of the planned sequence of hikes. The Fed has held down interest rates at very low levels, near zero for years, and now wants to raise rates with no large economic and financial consequences. That is not possible. Therefore, to answer the question, the Fed cannot raise interest rates.
There is no obvious way out of the corner into which the Fed and other central banks have painted themselves. They tried zero interest rates and large-scale asset purchases to no avail. The global recovery has been weak–for the U.S. perhaps the weakest in modern times. Hewing to their own logic, however, many central banks doubled-down and went negative. The Fed thus far has resisted that course and is even trying to move against the global tide and raise rates. Fed policymakers are still mostly stuck in closed economy thinking. But, so, too, are most advocates of monetary reform. New thinking is needed all around.
I thank Walker Todd for his insights.
Federal Reserve System H.15 Release — Selected Interest Rates (Weekly), August 8, 2016
Jordan, J. L. (2016) “The New Monetary Framework” Cato Journal 36 (Spring/Summer): 367-83.