The Fed’s Interest Rate

The Federal Open Market Committee (FOMC) is set to meet this week to issue its latest announcement on monetary policy.  It is expected that the Fed will not hike interest rates.

This means the Fed will not hike the federal funds rate, which is currently targeted in a range of 0.25% to 0.5%.  This is just a reflection of the interest that the Fed is paying to banks for their reserves.

In the past, the federal funds rate really meant something.  If the Fed increased this rate, it meant that it would likely have to contract the money supply in order to achieve its target rate.  It would have to sell assets to drive the rate higher.

But the federal funds rate isn’t dictating monetary policy as it used to.  Since QE1, QE2, and QE3, the banks have piled up massive excess reserves.  Monetary policy is not controlled by the Fed’s target rate.  The target rate was between zero and 0.25% for 7 years during three rounds of QE and delays in between.

Libertarians who understand monetary policy will say that the Fed artificially lowers interest rates.  This is generally true.  And it is true that low interest rates and a loose monetary policy generally go together, although not as much as in the past.

Right now, it is true in the sense that a higher federal funds rate might mean even less bank lending, which is equivalent to a tighter monetary policy.

Also, we have to realize that rates are really low right now because of previous policies of the Fed.  The Fed blew up the housing bubble and the general artificial boom that led to the deep downturn in 2008.  Then the Fed was aggressive with its monetary stimulus to a degree that has never been seen before.  It quintupled the monetary base over a 6-year period.

The low interest rate now isn’t just because of the Fed’s current policy.  It is a reflection of fear in the general economy.  It is a reflection of people and businesses not wanting to take on even more debt, despite the low rates.

There is a saying in the world of economics that the cure for low prices is low prices.  Or conversely, the cure for high prices is high prices.

Well, interest rates are prices.  When interest rates are low, it is a signal that there is plenty of savings.  The low rates will tend to discourage more savings and will encourage more borrowing.

If rates are high, it means that savings are too low.  This will signal borrowers to cut back because they will pay a higher price to borrow.  It also sends a signal for savers that they will get paid a higher rate for their savings.  It encourages less borrowing and more saving.

This all works out well except when the interest rate is distorted.  It sends false signals, usually with low rates signaling that there are more savings than what actually exists.

So while the Fed isn’t directly pushing rates lower right now, it seems there is still a disconnect and that the low rates do not really reflect market conditions.  Because if rates did reflect actual conditions, then it means that savings are really high right now.

I don’t think it is a matter of savings being high.  I think it is a matter of people just not having that much money to save.  And many are not going to borrow because they know they may not have the means to pay it back.

In other words, everything is a total mess right now.  Don’t try to figure out the “market” in regards to interest rates.  There are a lot of emotions and things at play that are driving this market.

I am still not betting against low interest rates at this point, at least in the short run.  If we fall into a recession, you can expect longer-term rates to go even lower.  U.S. bonds and Treasuries are still seen as a safe haven.

You may not think they are a safe haven, but it doesn’t really matter what you think.  It matters what everyone else thinks.  And as long as bonds are seen as safe, then you shouldn’t bet against them.

I think the one thing that will eventually drive rates higher is inflation fears.  That will come long before any fear of an actual default.

Before we get inflation fears, we will probably need to see more Fed money creation.  And before we see more Fed money creation, we will probably have to get a recession.

So if you ever want to short the U.S. bond market (bet on higher interest rates), then you should at least wait until the tail end of the next recession.

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