Tuesday, September 15, 2015

The Fed is About to Attempt the Greatest Monetary Experiment in History

For years, everyone involved with investing has wanted to know: When will the Federal Reserve raise interest rates?

But there’s another important consideration that isn’t asked nearly enough: Can the Fed raise interest rates?

That query is more than academic. With the US economy looking increasingly strong, some still think the Federal Reserve could act to raise rates after its monetary policy committee, the Federal Open Market Committee, meets this week (Sept. 16 and 17).

Such Fed rate increases used to be commonplace. But those days are long gone. It’s been roughly nine years since the US central bank last ratcheted up its once primary policy rate, known as the Fed funds rate.

And in the near decade since then, pretty much every rule, technique, and guideline the Fed once relied on has been drastically rewritten, revamped, or removed. That blank slate underscores the fact that seven years after the financial crisis, the US economy continues to feel the reverberations.

In the words of one analyst, when the Fed tries to raise interest rates “their actions will entail the largest monetary policy experiment in human history.”

Here’s what you need to understand it.

How rates move

Once upon a time, the Federal Reserve altered monetary policy by raising and lowering its target for the Fed funds rate.

What are Fed funds?

They’re the reserves that banks have to hold—for large banks a 10% fraction of their deposits—by law. These funds are essentially for safekeeping, and can’t be invested. (Though since 2008 the Fed has had the power to pay interest on them.)

But funds in excess of that 10% ratio can be invested and lent out within the Federal Reserve system. This is the Fed funds market, where banks that have more reserves than they need lend to banks that don’t have enough, usually on an overnight basis. And the cost of borrowing money in this market is the Fed funds rate.

Here’s the problem: Right now, everybody has way more reserves than they need. That’s because the Federal Reserve has pumped large volumes of reserves into the system in recent years, in an effort to first contain the financial crisis and, later, support economic growth.

How did the Fed push these reserves into the system? Easy. It created them out of thin air, and used them to buy government securities from banks.

And why did it do it? To push interest rates down. (Supply and demand creates prices. All else equal, a rising supply of reserves pushes the price of reserves—the Fed funds rate—down.)

Here’s the trick: Traditionally, in order to raise interest rates, the Fed has to find ways to suck some those reserves back out of the system.

But that’s gotten a lot harder to do.

by Matt Phillips, Quartz |  Read more:
Image: Andrew Harnik/AP