Monetary policy for dummies

October 19, 2018

News alert: Fed expect to increase rates to up to 3% within the next year.

What does this mean? Donald says it’ll ruin the economy and that the Fed is the “biggest threat” to his… presidency? Legitimacy? Economic policy?

Why does Donald want interest rates to stay low? Rates have stayed low since 2009, when rates were lowered to close to zero and held there for almost a decade. Monetary policy in the US even went as far as using quantitative easing to spur negative interest rates in the early 2010s. As the economy started to make a bit of a comeback, Fed chair Janet Yellen pretty much continuously hinted to the financial world about higher rates. Finally, in 2016, some moves were made to push the rate up. And since then, the Fed has been consistently poking and prodding financial institutions, ensuring that they are on their toes for the next rate hike.

Let’s start from the beginning. Interest rates represent the cost of borrowing money. The benchmark or target interest rate in the United States (the rate that all these articles are talking about) is a goal number for the federal funds rate. This rate is the rate at which banks loan money to each other to meet reserve requirements. A minimum reserve requirement is the amount of cash that a bank needs to hold at the Fed in order to remain compliant with the Fed and the government.

So every depository institution (bank) in the US needs to hold a certain percentage of their deposits in reserves. Throughout the day, a bank will receive funds and pay funds, leaving a certain amount left at the end of the day. If they are not able to meet the reserve requirement at the end of the day, a bank can borrow either directly from the Fed or from other financial institutions with a surplus in reserve funds. The rate at which the the bank borrows from the Federal Reserve is called the Fed discount rate, while the rate at which the bank borrows from other banks is the Fed funds rate.

So how does the Fed manipulate this rate? There are three knobs that the Fed can twist in order to manipulate the fed funds rate.

  1. Open market operations
  2. Fed discount rate
  3. Reserve requirements

First, open market operations. Open market operations are purchases and sales of government securities on the open market. In particular, the Fed buys and sells government bonds on the market in order to inject or remove money from the economy. When the Fed is buying, they are introducing more money into the market. In exchange for whatever government bonds that a commercial bank is holding, the Fed will deposit cash into that institutions’ reserves. This increases the bank’s lending power because they have more in reserves to meet their minimum reserve requirement. Since the banks have more to lend, their interest rates decrease (more supply leads to less expensive borrowing). This is expansionary monetary policy.

Quantitative easing is an extreme version of open market operations (OMO). When rates hit zero, other methods are needed in order to spur the economy on, since people would be unwilling to make deposits if their money simply dwindles in the account. Instead of limiting buybacks to short term government loans, the Fed moved to purchase mortgage-backed securities and longer term securities as well, injecting as much cash into the reserve system as possible to increase money supply.

On the other hand, if the Fed is selling on the open market, they are removing money from the market, decreasing lending power of institutions, and thus increasing the cost of borrowing. This is contractionary policy.

Second, the fed discount rate. The Fed sets its own interest rate on overnight loans to banks. This price on borrowing is set as a competitor to overnight loans between banks. Thus, there is pressure on banks to move their overnight rates with the federal discount rate. If the discount rate goes down, the cost of borrowing decreases, and so more money is flowing through the economy. This spurs economic activity and growth. This is a expansionary policy. If the discount rate goes up, the cost of borrowing from the Fed discount window goes up, and so other banks can afford to charge a higher rate for their overnight loans, thus disincentivizing banks to lend too much. Money flow slows down, and we have a contractionary policy.

Third, reserve requirements. The Fed sets reserve requirements on the amount of cash that banks need to hold against their liability position. This reserve will sit in a Federal reserve branch. Currently, reserve requirements depend on the size of a bank’s net deposits, and range between 3 to 10 percent. If a bank holds three thousand dollars in deposits when the reserve rate is 3%, this means they are permitted to loan up to $100,000. If the reserve rate is increased, banks have to ensure that more cash is on hand relative to their liabilities, which means they have less money to lend. Less money to lend leads to more expensive loans, which means less money is flowing through the market. This is a contractionary procedure.

On the other hand, if the reserve rate is decreased, banks are able to loan more money, which means they can lend at a lower rate, which in turn means that interest rates decrease. This is an expansionary policy.

So low fed funds rate = expansionary policy, while a high fed funds rate = contractionary policy. All of the methods above are really just controlling the supply of money in the economy. Pretty much all interest rates out there are in some way correlated with the fed funds rate. Mortgages, student loans, PLOCS, HELOCS, auto loans, and credit card APRs all move in tandem with the fed funds rate.

So why does Donald not approve of the potential for rising rates? Any sitting president would disapprove of the Fed raising rates, because the purpose of raising rates is to slow down the economy when it becomes to overheated. On the other hand, the president’s job is to tell people that the economy is doing absolutely fantastic, thanks to your vote.

There are several reasons why the Fed want to raise rates. The past few years have seen quite a solid bull run in the markets. This bull run seems a bit artificial, given the low cost of borrowing still in the market. A rate hike would force investors to reevaluate how much of the growth over the past several years was spurred on by loose monetary policy, and how much of it was true growth. It’s been a long time coming for a market correction and we’re seeing the effects of this reevaluation this year, in February market-wide and more recently in tech.

Another reason to raise rates it to provide breathing room for the next recession. One of the best tools we have to curb recession is the target interest rate, and if we can’t push it down, the only option is often last-resort techniques like quantitative easing. The Fed won’t want to inflate their balance sheet again with more meh holdings (no one wanted the mortgage-backed ones in 2009 anyway), so they’d probably like to stick to more traditional monetary policies.

There is also a concern about runaway inflation when it comes to low interest rates. When there is a larger money supply, the prices of goods increase, which means individuals have less purchasing power. One issue with the economic recovery over the last decade has been a decrease in purchasing power for consumers. Though prices of goods have been increasing, wages have not kept up with the pace. A higher interest rate will help curb inflation, in theory allowing wages to catch up to prices. Given today’s very low unemployment rates, demand is high in the labor market, which should (in theory) push up the price of labor (wages). The problem we are seeing now is that that is not happening, which indicates that we need to stop focusing on growth at breakneck pace. Historically, wage inflation lags behind price inflation, which is why rapid price inflation is not good.

Yes, rates should be increased, and no, it won’t look good on paper. But as China has shown recently, rapid economic growth is unsustainable for extended periods of time, and the Fed needs to keep the markets in check somehow. This is the best way to do it.

I get a lot of information from Investopedia.

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