I have come to the conclusion that few people truly understand how the Federal Reserve monetary policy works. I find that even the “experts” that are supposed to know better are often confused about this issue.
Frankly, I think all the talk about whether the Fed would raise interest rates a quarter of one percent is a waste of time.
Some time ago I wrote about the pessimists’ forecasts of impending doom because of an “out of control fed” – their words, not mine. Surely you remember all the commercials about Gold, and how it would rise to $5,000 per ounce? We were certain to suffer from hyperinflation, a crashing dollar, a stock market that was doomed along with a spike in interest rates…all because the Fed was “printing trillions of dollars.”
In essence, when the Fed created money to buy bonds from the banking system, for the most part, all the banks that sold the bonds to the Fed ended up keeping the money in excess reserves where they could earn 0.25% in interest paid by the Fed as opposed to 0% to 0.10% had the banks loaned the money out overnight to other banks. This is what most people missed. The experts all missed the fact that the Federal Reserve, for the first time, paid interest on excess reserves in the banking system.
This is all backed up by the data on money supply, which has risen by 6% or so per year since 2008 – compared to the growth of the Federal Reserve’s balance sheet which has increased at an annual rate of around 25%.
It is clear to me that many people today cling to the belief that the key mechanism the Fed uses interest rate changes. This has never been the case. In reality, changes in monetary policy have always been transmitted by the Fed by adding or subtracting reserves from the banking system.
While this policy does move interest rates, this only occurs because when the Fed sells bonds to banks, it reduces the liquidity in the banking system. This does have an impact on the economy as you might imagine. However, this is not caused by the increase in rates, but rather as a result of the slowdown in the growth of money.
Nowhere did I hear anyone say that the Chair Yellen contemplated decreasing reserves in the banking system. All of those reserves remain as excess reserves in the banking system today and had the Fed increased rates last week, it would not have had any impact on the level of reserves.
Though I didn’t have a concern one way or another, I didn’t expect the Fed to increase rates for three reasons that still remain.
First, the global economy is not in very good shape. Yes, the U.S. is in much better shape than many countries, but at best it can be thought of as somewhat sluggish. Second, a rise in interest would increase the value of the U.S. dollar, making it even harder to sell exports.
Finally, with year over year inflation at around 0.3%, well below the Fed’s target rate of 2%, it’s hard to see the case for increasing interest rates.