The Nitty-Gritty of Fed Rate Hikes

For the past two or more years the question of whether or not (and when) the Fed might “raise interest rates” has been a constant feature in the news. With the FOMC, the Fed’s rate setting body, meeting next week, this is especially true at the moment. But no one seems to understand the nitty-gritty of just how interest rates are raised (or lowered), and very few non-economists have any knowledge of how it happens.

At times, the news reports seem to suggest that somewhere within the bowels of the New York Fed there is an interest-rate-machine, and that the monetary authorities have only to push a button, and, Voila!, interest rates will be raised. No one asks just how much they might be increased, or what happens then, although some accounts suggest that such an action would signal an end to the stagnant economy and better times ahead.

The Fed has no interest rate machine. To “hike rates” the Fed Open Market Committee (FOMC) must use its power to diminish the economy’s quantity of spending money through its control over the Monetary Base (MB), which is the accounted sum of the monetary obligations of the 12 Fed Banks. This Base includes two liabilities of the Fed Banks—the stock of hand-to-hand currency and the reserve-deposits of almost all of the commercial banks. To hike rates, the FOMC must decide to SELL government securities in the financial markets from its huge stockpile of security holdings—think ‘national debt.’ Fed Banks have accumulated these securities by previous purchases that lowered rates and increased the economy’s stock of money. Now, however, the call is for a ‘rate hike’ so the FOMC would have to sell off some of the Fed’s securities. It would make the sale through the offices of the Fed Bank of NY, by offering them on the financial market at attractive (low) prices relative to the annual dollar payments the securities promise their holders.

A large fraction of the sales would be to commercial banks thereby reducing their reserves, which would ordinarily force them , in turn, to reduce their lending to business firms. However, the banks at the moment have a huge volume of excess reserves on which they get one-fourth of one percent (0.25%) interest from the Fed Banks. These reserves are “excess” because they are not being utilized to “back” checkbook deposits that all households and businesses count (properly) as money. If the reserves had been used to finance the investments of private business , industry and households, the economy’s accounted stock of money would be perhaps double what it is now. But a large fraction of the Reserves has been “sterilized” by the device of this trivial interest rate paid on them.

With the FOMC buying, however, market rates might rise enough so that commercial banks would use up these sequestered reserves, and the depressing effect of a ‘rate hike’ might be avoided. But no one knows for sure. That’s why the officers in the Fed system are procrastinating.

Another important factor is also in the picture: the huge annual government deficit of more than a trillion dollars that must be funded every year. A ‘rate hike’ would make these annual borrowings much more difficult for the U.S. Treasury to finance. And if the fiscal problem becomes unstable—more deficit to finance than security markets will allow, the Fed will obey its political masters and finance the deficit by a hyper-inflation, or hyper-tax, as a burgeoning inflation simply taxes all fixed dollar wealth—bonds, dollars, life insurance values, etc.—by the rate of price level increase.

Finally, we might ask: ‘Why are rates so pervasively low. And why haven’t previous Fed and Treasury spending policies provided a path back to a healthy economy?’

The answer is that the Fed controls the monetary system, but it does not control the real system — the production of goods, services, and capital. The real system also has an interest rate — the real interest rate. At the moment, the real rate is effectively zero, because its determinants — the real rate of gross private domestic investment, and the real savings to finance those investments — are near zero. Taxes, regulations — the “Ten Thousand Commandments,” litigation, and harassment of venture capital has alienated real investment severely. Consequently, no matter what the Fed does or does not do, real values, including real incomes, are going to remain depressed into the foreseeable future. No amount of money and no monetary policy is going to change the government-imposed real depression.

[Cross-posted from Alt-M.org]