Tuesday, September 22, 2015

The Fed and Interest Rates

For many years – and certainly more so since 2007 – all financial markets have been fixated on the Fed.  There has also always been discussion regarding the Fed in the circle of economists and economics and, more to the point of this post, Austrian economists and economics

I am no economist of any stripe, and I have freely written that I am not a student (in a meaningful academic sense) of Austrian economics; just a tremendously sympathetic layperson.  To the extent I comment on economic topics, I do so from a foundation of two perspectives: first, my support for free markets; second, no two humans are wired the same. 

It just so happens that Austrian economic thought hews most closely to these two points.  I guess you could say that this makes me a “so-called” Austrian!

Robert Wenzel has published a few posts regarding the Fed’s latest (in)decision on interest rates.  His most recent post on the topic is what has prompted me to write this one.  His post got me to thinking on several topics around this issue – all topics that have been swirling around in my mind for several years, yet topics about which I have written little if anything.

What rates can the Fed directly influence?

First is the rate charged by the Fed for a member bank to borrow at the discount window:

The discount window is an instrument of monetary policy (usually controlled by central banks) that allows eligible institutions to borrow money from the central bank, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions. The term originated with the practice of sending a bank representative to a reserve bank teller window when a bank needed to borrow money.

In the United States, there are actually several different rates charged to institutions borrowing at the Discount Window.

Then there is the rate paid on excess reserves:

In banking, excess reserves are bank reserves in excess of a reserve requirement set by a central bank. They are reserves of cash more than the required amounts.

In the United States, bank reserves are held as FRB (Federal Reserve Bank) credit in FRB accounts; they are not separated into separate "minimum reserves" and "excess reserves" accounts.

On October 3, 2008, Section 128 of the Emergency Economic Stabilization Act of 2008 allowed the Fed to begin paying interest on excess reserve balances ("IOER") as well as required reserves. They began doing so three days later.

As far as I see, that’s it for direct influence – two rates.  If I am missing something, don’t be shy about letting me know.

Two rates – that isn’t much

It gets worse.

The rate charged at the discount window is almost meaningless when banks are sitting on something close to $2.5 trillion of excess reserves (my discussion regarding excess reserves throughout this post assumes that all major money-center banks are well endowed in this regard; minor banks are reasonably irrelevant.  If such a breakdown by bank exists, I haven’t seen it).  Why would banks, flush with such liquidity, have to borrow at the discount window to resolve issues of liquidity?

In fact, after a significant spike in 2008 / 2009, borrowings at the discount window have been negligible, in the $100MM - $200MM range on average, and often below even this.  Compared to $2.5 trillion of excess reserves available, hardly noticeable; 0.006%, more or less.

This leaves me with the conclusion that the only meaningful rate that the Fed can directly control in today’s world is the rate paid on excess reserves.  The Fed could raise this rate.  As all financial returns in reasonably robust markets are derived one from another, this would likely have the indirect effect of increasing the return banks require for lending to third parties.

What rates can the Fed indirectly influence?

In the United States, the federal funds rate is "the interest rate" at which depository institutions (banks and credit unions) actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances. The federal funds rate is an important benchmark in financial markets.

The interest rate that the borrowing bank pays to the lending bank to borrow the funds is negotiated between the two banks, and the weighted average of this rate across all such transactions is the federal funds effective rate.

The federal funds target rate is determined by a meeting of the members of the Federal Open Market Committee which normally occurs eight times a year about seven weeks apart. The committee may also hold additional meetings and implement target rate changes outside of its normal schedule.

The Federal Reserve uses open market operations to influence the supply of money in the U.S. economy to make the federal funds effective rate follow the federal funds target rate.

Finally (I think, but again am willing to be shown otherwise), open market operations (broader than implied above):

An open market operation (OMO) is an activity by a central bank to buy or sell government bonds on the open market. A central bank uses them as the primary means of implementing monetary policy. The usual aim of open market operations is to manipulate the short-term interest rate and the supply of base money in an economy, and thus indirectly control the total money supply, in effect expanding money or contracting the money supply. This involves meeting the demand of base money at the target interest rate by buying and selling government securities, or other financial instruments.

That’s it, as far as I can find.

Only two again?

Maybe zero by the time I get through this.

You will note that the banks negotiate the federal funds rate amongst themselves; the Fed can only influence this rate via open market operations.

So let’s say that the Fed decides to influence this rate via open market operations.  What good would it do?  The banks are sitting on about $2.5 trillion of excess reserves.  Why would they have to borrow (in any meaningful way) from each other?

Again, after a spike in 2008 / 2009, the amount of interbank loans has steadily come down to an almost insignificant amount – below $70 billion, less than 0.003% of the $2.5 trillion in reserves.

As to the buying and selling of other, longer-term assets, the Fed could indirectly affect interest rates by selling some portion of assets held on its balance sheet, today over $4 trillion – and something like five times the balance held prior to 2007.  As the Fed sells assets, all else equal the price of comparable (and other) financial assets will decline – raising rates.

But is this correct?  Banks have about $2.5 trillion in excess reserves.  Banks could buy $2.5 trillion of assets from the Fed and not contract lending by a penny.  The Fed can increase the supply of securities on the market without at all affecting the supply of liquidity currently available to the market. 

Demand for credit from the market is unchanged; supply of credit available to the market is unchanged.  So how does the price of credit change?  I think this does almost nothing to interest rates. 

I think.

So then why is the Fed holding these assets at all?

Currently banks earn something like 0.25% on their excess balances.  I am willing to bet that there are at least $2.5 trillion of Fed-held assets that pay something more than this.  Why don’t the banks scoop up this windfall of interest income?

I can think of two reasons: first, there are more non-performing assets than anyone is willing to admit; second, the Fed and the banks are buying insurance.  Both could be true.

It is not unreasonable to believe many of the Fed’s assets are not performing, or they are performing but at a level far below the value as represented on the Fed’s balance sheet.  The banks might be willing to buy these at market value, but the Fed would then have realized losses to explain (although this raises an entirely different line of questions; can the Fed go insolvent?).  In any case, I don’t believe the truth behind any of this is visible to the general public.

As to insurance: remember 2007 / 2008.  A system with no excess reserves was daily selling assets or shrinking credit availability in order to meet liquidity requirements.  Market prices were in something approaching free-fall.  With $2.5 trillion in excess reserves today, this won’t happen again.  This is the insurance being bought.

Where Does this Leave the Fed?

In the long term, markets win.  In the short term, the Fed (historically) has been able to greatly influence rates.

With that said, I think the Fed today has a tiger by the tail.  I believe the Fed’s only means to regain some control over interest rates is to first sell enough of its balance sheet assets to bring excess reserves back down to negligible levels.  They aren’t doing so and they likely have a couple of strong reasons not to do so (as noted above).

This suggests that markets are fully in charge of rates – in the short term and longer term.  This further suggests that perhaps we shouldn’t be blaming today’s low interest rates on the Fed.  Of course, when buying the assets (from 2008 – 2014), their actions drove prices up (all else equal), hence rates down.  But they haven’t moved the balance sheet in any meaningful manner – sitting at about $4.4 trillion – for over a year.

The level of excess reserves has dramatically changed everything about the analysis of the subject of the Fed and interest rates.  With today’s level of excess reserves, it seems to me that the tools of the discount window, federal funds target and broader open market operations are close to impotent.

All that is left is the rate paid on excess reserves.  The Fed can increase this (in order to indirectly influence bank lending rates higher).  Maybe the Fed has developed other tools, designed to be effective in this world of excess reserves.  It is possible – they pay a lot of bright people a lot of money to figure stuff out.

It is possible, but by definition it has never been tested in any meaningful way.  So who can say regarding the effectiveness of any such new tools, granting that such might exist.

With price inflation benign, I still grapple with why the Fed would do anything to raise (or try to raise) rates (setting aside how, being the point of this post) – other than to portray to markets that the Fed is watchful and diligent.  This can only lead to the possibility that the Fed will be behind the curve when price inflation eventually starts to become a politically untenable situation.

When?  I know enough about Austrian economics to say that this discipline offers no answer to this question!

My Appeal

I am stuck on this issue as described above – the effect that substantial excess reserves have on everything we thought we knew about money and credit, interest rates, etc.  I may be all messed up on a fundamental (and in hindsight, obvious) concept; I may be wrong on certain details.  If anyone has answers, I am all eyes – and you will have my thanks.

The Fed will raise rates.  Which rates?  How? Will this affect other rates?  How?  Without clear answers to these, I am left to conclude that the markets are today in charge and the Fed has a tiger by the tail.  Absent a drastic reduction in excess reserves via the Fed selling assets into the market or the banks greatly increasing lending, all the Fed can do is increase the rate paid for excess reserves.

Or jawbone.


  1. Gary North had a similar take on the idea that the Fed can raise rates. I'm not sure. It seems to me there are things they could do, if they so choose. They can't set the rates by fiat, but they can influence them.

    They can stop re-investing the money they collect on bonds they own - principal and interest - thereby reducing the demand for them. That wouldn't be enough in itself, I don't think. Also, as China dumps treasuries, they could forgo buying them all up. China supposedly dumped $100B in treasuries in August. If the Fed decided to, for example, only buy half of that amount then that might serve to raise the rates. But I don't think they will.

    Igor Karbinovskiy

    1. Igor, thank you for the comment.

      I am familiar with North's writing on this; in addition to his view on the Fed's difficulty in increasing interest rates, he also writes that the market is currently holding rates down, not the Fed. He would write these conclusions, but I could never understand why / how he reached these.

      I heard this from him but never spent enough time thinking about it until I wrote this post. By working my way through this post (and also coming to similar conclusions...at least for now), I think I understand why he believes these two points.

  2. Robert Prechter (firmly in the deflation camp) has been saying that the market is in control of interest rates. The charts in this article are eye opening. http://www.elliottwave.com/freeupdates/archives/2014/06/24/Interest-Rates-Think-the-Fed-Is-in-Control-Think-Again..aspx#axzz3mVIvn1Ai

    They may not answer your questions, but certainly do lend some support to your observation.

    1. Thank you for the link.

      Although I haven't looked into it in any depth, I tend to agree that the Fed follows markets and does not lead them.

      However my point is something slightly different. In the charts (in the provided link), the data is pre- significant excess reserves. I think I am concluding that it is because of the excess reserves that most of the Fed's tools are today impotent. Even if the Fed wanted to lead the market today, it could not (whereas the Fed could have led the market pre-2008 if it so chose).

      In fact, one could conclude that one of the key reasons that the Fed implemented paying interest on the excess reserves is so it would have available one effective policy tool, as opposed to none.