Tuesday, November 17, 2015

Lesson 11 The Fed and Raising Interest Rates

You would have to be a starving artist or an ex high school football star to not notice that just about everyone is talking about the possibility that the US Federal Reserve is on the cusp of raising interest rates in the USA. Some of us like the idea of higher interest rates because we are old and want our saving accounts to grow faster. Others hate the idea because higher rates make it more expensive to borrow. And with less national borrowing those people worry that the economy might tip into another recession.

You can’t get into an Uber car or stand in the check-out line at Lucky’s Food Market without hearing people talk about the Fed and interest rates. So I thought it might be nice to sit here and sip and tell you everything I know about the Fed and interest rates. The first reminder is that the Fed has no direct effect on most interest rates. It is sort of like Uncle Bob. Aunt Cami can yell at Uncle Bob to rake the leaves. But Uncle Bob is Uncle Bob and he will rake those leaves when he is good and ready to do so. Of course if Aunt Cami yells loud and long enough she might influence him. And that’s the way the Fed works. The Fed cannot use an interest rate app to dial-up a mortgage rate or a car loan rate. 

Capitalists like me would say that interest rates are set in markets and are determined by the dynamic interaction of savers and investors. Or you might say interest rate changes arise from the interactions of bankers and other financial firms with the rest of us. Either way, you are acknowledging that rates on car loans or mortgages generally rise when people want to borrow more money. They fall when borrowers are fewer but banks are full of extra cash.

So what is it with the Fed and interest rates? Like Aunt Cami (and Uncle Bob), the Fed has a few tools it uses to influence savers and investors. The Fed can influence expectations by whispering they are planning to influence rates in one direction or another. That would be like Aunt Cami saying that she is growing impatient and is on the verge of yelling at Uncle Bob. Sometimes that works and Uncle Bob starts raking like a team of banshees. If that doesn’t work the Fed can go to Plan B or do what’s called quantitative easing and act as a very large buyer or seller of mortgages or other loans. Thus the Fed’s activity in the markets affects the supply and/or demand for assets – assets whose rates they are trying to influence. I am told that QE is not being used now. So that leaves us with something called the Federal Funds Rate (FFR).

The FFR is something akin to a quark.  Most of us will never see, smell or touch a FFR – unless you are a banker. The FFR is the rate of interest on a loan between two banks. Bank A has extra money. Bank B has a juicy new loan prospect but no money. So Bank A loans its excess to Bank B. Bank A charges Bank B the FFR. And we all live happily ever after. 

But what happens if all the banks want to lend to clients and none of the banks have extra cash? That is when Supergirl – er I mean the Fed steps in. The Fed buys government bonds from banks – thus adding liquidity or money to the banking system. This not only gives banks more money for loans but it also keeps the FFR low. As this amounts to a lower cost of funds for banks – banks can now keep  car loan and mortgage rates low too.

To raise interest rates the Fed does the opposite. To raise the FFR the Fed sells government bonds to banks – drawing money out of the system making money costlier. Bankers may or may not pass these costs along to people who borrow. But often it does work that way. So we say the Fed influences most market rates as it moves the FFR up and down.

In short the Fed can affect market interest rates and the world is watching to see if they will start raising the FFR this December. Lets suppose they do start doing this in December. How much will the FFR rise initially? How much will it rise in total over time? How long will the Fed keep the FFR high? One way to answer these questions is to look back at other times the Fed started raising interest rates.

So I plotted some FFR data – quarterly data – from 1980 to present. And here is what I found. See the table below for the details.
(1) Since 1980 there have been five times when the Fed moved to raise interest rates.
(2) Typically rates rose for 4-5 quarters but in 2004 the increase went on for almost three years (11 quarters). 
(3) Notice also that the rate at the beginning of the rising cycle was only 1.4% in 2004. During the four other episodes the initial rate was already pretty high averaging from 4.8% to 8.8%.
(4) The average rate increase in the first quarter  was about 54 basis points – or less than half a percentage point. For example in 2004 the rate was initially raised from 1.4% to about 1.9%.
(5) Over the full course of the policy period rates rose by an average of 267 points. The FFR increases were anywhere from 177 points to 382 points. In 2004 the rate started at 1.4%, immediately went to 1.9% and then over three years rose to about 5.2%. 

Year    #Qtrs Rate    Increase1   Increase2
1983      5      8.8      66                   259
1988      5      6.7      52                   307
1994      4      3.9      66                   208
1999      5      4.8      34                   177
2004    11      1.4      52                   382

Year is when the FFR began rising
#Qtrs is the number of quarters until the FFR declined
Rate is the value of the FFR at the beginning of the cycle
Increase1 is the number of basis points the FFR increased in the first quarter
Increase2 is the number of basis points the FFR increased before it decreased

The past can only be a rough guide to the future. 2016 will not be a copycat of any of these previous five cycles. It won’t exactly copy the past because 2016 will not be the same as the years before those past interest raising cycles.

But the past always informs and helps to put things into perspective. Rates do not usually rise by huge amounts and the tightening spells have lasted between one and almost three years.

At the end of 2015 rates are historically low and the world economy is barely moving along. Thus, market forces are not expected to present much pressure toward raising interest rates in the near future.  Most economists are predicting an initial FFR rise in the neighborhood of maybe 25 basis points. Should the Fed raise the FFR by 25 points in December or in early 2016 it does not follow that rates will swiftly climb in the next four quarters. In fact it is altogether possible that the 2016 cycle will be much more like the 2004 cycle than any of the others.      

The key takeaway is that the hullabaloo over when the Fed will begin raising rates is nothing compared to the anxiety that will arise once it begins raising rates. The drama will have only begun. Stepping to the open door of an aircraft flying at 12,000 feet is daunting but only the beginning of the story. 


  1. I smelled a quark once...not an experience I want to repeat. I'm pretty sure my roommate had eaten a couple of chili dogs at the Varsity.

    Question: do the banks have to buy government bonds when they're offered by the Fed? What if a bunch of them said,"That's just worthless paper and we already have too much?" I'm sure it would never happen, but what if?

    1. Those dogs at the V will do it every time.

      It is not so much a question as to whether or not the banks will buy -- it is more at what price. If the Fed is vigorously selling bonds and the banks don't buy, then the price of the bonds goes down even more and the interest rate goes up even more. This makes it more attractive for the banks to buy the bonds. Right now with so much money sitting around you would think that banks wouldn't mind having more bonds and would be willing to buy them...thus preventing rates from rising. Kapische?

      But in general the more banks resist what the Fed is doing in the market the harder it is for the Fed to obtain its interest rate objective.