When dreaming I’m guided to another world. Time and time again. At sunrise I fight to stay asleep, ‘cause I don’t want to leave the comfort of this place, ‘cause there’s a hunger, a longing to escape from the life I live when I’m awake. So let’s go there, let’s make our escape. Come on, let’s go there. Let’s ask can we stay? Can you take me higher? To the place where blind men see. Can you take me higher? To the place with golden streets. I guess that the Federal Reserve Chair was listening to the 1999 song from the post-grunge rock band Creed last week when she finally deemed it appropriate to raise the Federal Funds target rate by a whopping 25 basis points to 0.5 percent. The rate, which had been at just 25 basis points since the end of 2008, nearly 84 months, and the entire growth period of the current business cycle, is the interest rate at which banks and credit unions lend reserve balances to each other on an overnight, uncollateralized basis.
For years pundits and the business press has speculated about when this increase – what they are dubbing as “lift-off” would occur, and how it would, help the stock market, hurt the stock market, lead to inflation, lessen inflation, strengthen the dollar, weaken the dollar, etc. In other words, this is not a place where blind men see, and the business press has no idea as to what the effect of this “lift-off” would be. The reason for this is likely that under most situations, the target federal funds rate really does not matter very much.
The inter-bank loan rate only matters when banks need to borrow from each other in order to ensure that they have sufficient reserve requirements. Generally, this is necessary only when the economy is growing quickly and there is tremendous demand for credit, or when the economy is declining rapidly and banks are seeing their balance sheets weaken. In the current, stagnant economic environment minor changes in the Federal Funds rate are meaningless. In fact, the effective federal funds rate, (the rate that banks are actually charging each other), is well below the 25 basis point target rate. The reason for this is that banks simply do not need to lend to each other. All of the major money center banks are holding huge reserves of currency which was printed and deposited by the Federal Reserve since 2008. In fact, interbank lending is down from $443.8 billion at the beginning of 2008 to just $60.5 billion at the end of October 2015. With the lack of demand for capital, banks do not need to lend to each other and the target federal funds rate – be it 25 bps or 50 bps or 500 bps – is meaningless from an economic sense.
This can be seen in the fact that commercial lending rates are continuing to fall, and have so since the recession. The most recent Federal Reserve data has the average 30 year mortgage at just 3.76 percent, about 40 percent lower than it was when the Fed dropped its target rate to 25 bps. And even with its massive borrowing binge, the rate on 10 year Treasury Bills is 7 percent lower than it was in December of 2008 when the target rate was lowered to 25 bps. In other words, there is very little demand for credit in the US right now and interest rates are not likely to rise until such point where there is demand.
So why the hype? Well in a normal interest rate environment the target federal funds rate generally follows the demand for money with a short lag. It is the canary in the coal mine signaling when there is a problem. Analysts, believing that the Federal Reserve had better information than they did, or had some magic unicorn powers, would follow the interest rate as a guide to what inflation or the economy was going to do. So an increase in interest rates would signal that there were inflationary pressures and that the economy was growing. On the other hand reductions in the rate were considered a sign that the economy was softening.
The current state of the economy; however, is not really being governed by monetary policy. Business formation, retail sales, wages, production and all of the other indicators of a healthy economy grew very slowly after the recession in spite of the lowest interest rates on record. Now, the economy is showing serious signals that it is moving into recession and the Fed is actually raising rates. In reality, the Fed has showed it hand and revealed to the world that it really does not control interest rates to a great extent and that its touted monetary policy is more a canard than a canary.
It is unlikely that interest rates are going to rise higher following this “lift-off” unless for some reason the economy begins to grow faster than it has over the entire 7 years of the recovery (remember the economy began to shrink during the 2nd quarter of 2008 and the recession bottomed out in the second quarter of 2009). Without some exogenous factor like the discovery of fusion power, or some other major technological breakthrough, this is very unlikely to happen. So expect interest rates to likely fall over the coming months, not as the pundits would suggest, go higher.