Why Everyone Is Wrong on the Fed and Interest Rates

Since the beginning of the year, the Federal Reserve has held court in financial markets. When and how much will it raise interest rates? If the question has been raised once, it’s been raised thousands of times over the past five months.federal-reserve-interest-rates
Most everyone accepts a Fed rate hike as a given. The Fed will raise interest rates this year. Now it’s just a matter of setting a target rate.
Conspicuously absent in the burble is any acknowledgment that the Fed lacks omnipotence. The Fed can influence, but it can’t dictate, interest rates. What’s more, the interest rate everyone points to – the federal funds rate – might be completely beyond the Fed’s control.
You might ask why the federal funds rate matters. It is the overnight lending rate banks charge to lend to each other. The federal funds rate cascades. Movements in the federal funds rate are passed on to other short-term interest rates. Movements in short-term interest rates, in turn, influence long-term interest rates, such as rates on corporate bonds and residential mortgages.
The Fed hasn’t raised the federal funds rate in nearly 10 years. Since early 2009, the Fed has set a target rate of 0.0% to 0.25%.
In bygone days – pre-2009 –  the Fed would set a target range for the fed funds rate and the banks would follow the range. They had no choice. A bank must hold reserves with the Fed if it wants to lend.
Historically, banks held very little reserves, and for good reason. Reserves were sterile and earned no income. Banks rationally wanted to keep reserves to the bare minimum. Better to run short-term deficits and have to borrow at the fed funds rate than to maintain excess reserves.
Today, it’s different. Bank excess reserves approach $2.6 trillion due to the Fed’s asset purchase program – quantitative easing –  that ran through October 2014. What’s more, the Fed now pays interest on these reserves, at 25 basis points. By paying interest, the Fed theoretically puts a floor on the federal funds rate. No bank would lend for less than 25 basis points when it can earn 25 basis points the Fed pays on reserves.
Why, then, is the federal funds rate 13 basis points?
Government-sponsored entities (GSEs) serve as an escape valve. Because one government agency is prohibited to pay interest to another government agency, the Fed cannot pay interest to government agencies that hold reserves at the Fed. This includes GSEs Fannie Mae, Ginnie Mae, Freddie Mac and the Federal Home Loan Banks. The opportunity costs to lend in the federal funds markets isn’t 25 basis points for the GSEs, as it is for the commercial banks – it’s zero. These institutions can lend below the interest rate the Fed pays on excess reserves.
The GSEs supply loans; not that there is much demand. With excess reserves running so high, most commercial banks are able to meet their reserve requirements. This is why the federal funds rate is 13 basis points, not 25.
For the Fed to raise the federal funds rate, it needs to shore up the floor. Legislation could be passed that provides an exception for the GSEs. The Fed could start to pay interest on GSE reserves held at the Federal Reserve, to prevent GSEs from undercutting the Fed.
The Fed could also reclaim its hold on excess reserves by drastically shrinking excess reserves. The Fed could sell $2.6 trillion of the $4.5 billion of the U.S. Treasury and mortgage-back securities it has on account. This would drain excess reserves and again subjugate banks to the federal funds rate.
Unfortunately, the Fed would need to sell debt in excess of $2.6 trillion because of the precipitous drop in value and rise in yield demanded for these securities. Worse yet, potential losses would likely wipe out the Fed’s $58 billion capital base.
Therefore, it’s little wonder that the Fed has drug its feet on raising interest rates. It can’t.

Six times BIGGER Dividends – with this one stock 

The average yield of the Dow has sunk to 2.1%. That’s just sad. However, we know of one group of investors collecting up to $550 every 30 days from a little-known investment that yields a whopping 12%! That’s roughly six times bigger than the average yield of the Dow. If you’d like to tap into this income stream, and earn six times bigger dividends, click here for our full report on this opportunity. 

To top