Fed Policy and the Market

As the (red line in the) below chart shows, the US Federal Reserve is embarking on a new policy to lift interest rates gradually back to normal levels. Today's post suggests that even if the Fed keeps to its goal of raising the Federal Funds rate gradually in the coming year, the Fed might not get what it is hoping for.

To convince you that this is no slam dunk (to raise market interest rates), it takes a little excursion into interest rates and then a closer look at the below graph.

Let's start with interest rates. There are many interest rates out there, and the Fed has no direct control over them. You can think about an interest rate in two ways -- as a saver or as a borrower. When you put your life savings into your money market account, you soon learn that with today's low interest rates you get enough return to buy yourself maybe 15 minutes on a Bloomington parking meter. If you instead lend the money to the government by buying a long-term government bond, you might get an interest rate of about 2.8%. That means if you buy a bond for $100, you will get back the sum of $2.80 each year you own the bond. That return amounts to a coffee of the day at Peet's. No refills.

You might instead want to borrow money. Most of us borrow for a car or a home or a month's supply of JD. In that case, you would pay the interest rate on a car loan or mortgage rate or whatever rate your friendly credit company charges.

Whether a saver or a borrower, you experience interest rates, and the fact is that interest rates are not set by the Fed or the government or even Santa. Interest rates, prices of stocks and peanuts, respond to market forces. If in today's market everyone wants to borrow and no one wants to lend, this tends to raise interest rates. If tomorrow most people are interested in lending and there are few borrowers around, then interest rates fall. We say interest rates are mostly market driven.

A quick look at the blue line (interest rate on a government bond with a 10 year maturity) in the graph below shows you that interest rates have a pretty exciting life. And this graph only shows you 1999 to present. A graph going back to the 1960s would make your head swim. Remember those 20% interest rates in the 1970s?

Okay, so rates are determined by market forces. Where does the Fed come in? Like most government entities, the Fed likes to try to make the world better. The way the Fed does this is to try to raise interest rates when the economy is acting like a runaway train car. Or when the economy gets slow and creepy, the Fed tries to stoke it with lower interest rates.

I keep saying "tries" because the Fed does not tell banks and other financial institutions how much to charge on auto loans or mortgages. But the Fed can try to influence these rates through its control over something called the Federal Funds Rate (FFR). The Fed sets goals for the FFR and can reach those goals by intervening in something called the FF market where bankers loan each other money on a  daily basis. It's too long a story for the blog today but just take it for granted that the Fed can take actions which either decrease or increase the FFR.

The FFR is the red line below. A quick review: the Fed altered policy several times since 1999, first raising the FFR, then reducing it only to raise it again. It bottomed out at the end of 2008 and was kept near zero until recently. November 2015 marks a turning point in which the Fed started raising the FFR. We are told that since the economy is now humming along at about 70 miles per hour, they need to raise rates to cool things off a bit. Plans are to increase the FFR several times into 2018.

Why raise rates? Presumably because a near-zero percent interest is not normal and it tends to penalize savers. Some think it might make savers want to take on too much risk by buying bitcoins or 8-track players. Whatever the reason, the goal today is to raise the FFR. The goal is to have the rise in the FFR spillover and influence all those other market rates. The chart below is instructive in that regard. We can look at the relationship between the FFR and the interest rate on government bonds with a 10-year maturity (I chose this one market rate because there are just too many too choose from and this one has the reputation of being a good indicator of what is happening to most rates.)

Notice in the chart that increases in the FFR do not always result in higher interest rates.

• After 1999, the FFR increased to almost 7% while the 10-year rate started to rise but then fell.
• After 2004, the FFR went from 1% to over 5% yet the 10-year rate bobbed up and down like a tuna in a shark tank and ended up only a smidge higher than it has been in the recent past.
• After 2016, the FFR gently increased while the 10-year rate's downward trend was only interrupted in 2017. But notice that the 10-year rate today remains below its peak value in 2014 and is well below other previous peaks.

Since you are still a bit slow from your New Years' partying, I will refrain from taking this much further. But the obvious question to ask at this point is why the 10 year rate has been so fickle. It is supposed to do what the FFR tells it to do. The bottom line is that market rates are impacted by many things -- psychological and other -- and only one of those many things is the level of the FFR. The chart shows how important markets are to interest rates and why it is possible that Fed policy may not succeed in its goal to protect the US economy from immodest growth. Worth speculating about at George and Wendy's is the long-term downward trend observed in the graph. The 10-year rate has been on a downward slope for about 17 years. I wonder what it will take in the way of Fed policy to reverse that.

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. 

Fed Tales

Those of you who can count will notice this is my third post in recent weeks about the Fed. Okay – I am a Fed-O-Holic and I have to observe a three drink limit.  So I promise not to write another one about the Fed for at least a week unless they deserve it.

I love to write about the Fed. I spent my career teaching, researching, and writing about monetary policy. I am still capable of emptying a perfectly good room when I start to pontificate about Fed policies. But that hardly stops me. Since I am old, that means that I have seen a lot of change and witnessed, if nothing else, the disconnection between Fed policy hopes and realities.

As smart modern people we believe that learning is natural and possible. We watch a two-year-old fall down repeatedly only to finally learn how to straddle even the tallest bar stool. It is only in the realm of federal institutions, however, that it seems learning is next to impossible. And the Fed is a federal institution. While it is technically independent from governmental institutions like Bob Dole and the Supreme Court, The Fed is obviously impacted by hopes and dreams and Nancy Pelosi.

I was motivated this week to write about the Fed because of the many articles being written these days about how the Fed is going to fine tune the coming increases in interest rates. That sounds hopeful doesn’t it? Imagine Janet Yellen and her colleagues standing behind a large high tech machine. Janet yells out – interest rates up 20 points this week. Aye Aye Capn says the FOMC and magically all the newspapers report a rise of exactly 20 basis points. Capn Yellen is hoisted onto Michelle Obama’s ample but sexy shoulders and they all march out of Washington singing Federal Reserve Drinking Songs. We raised the interest rate 20 points hurrah hurrah (to the tune of Johnnie Comes Marching Home Again).

Seriously. Can it be possible that we lived through millions of years of Federal Reserve policy and we still believe it when the Fed Chair tells us they are going to manage the upward (or downward) movement of the interest rate? It is not dissimilar to believing in the tooth fairy. Jimmy says – Mommy, is the Tooth Fairy going to bring me a new Harley Davidson if you put my bloody tooth under the pillow tonight? Of course, honey. The Tooth Fairy wants to know if you want saddle bags or not.

No I am not drinking JD (at the moment). Then why all the silliness about such a serious topic? The answer is that somehow because Fed policy is both technical and complicated we are prone to believing the largest fibs since Bill Clinton said he didn’t get busy with that person.

Why even worry about Fed fairy tales? Fairy Tales are wonderful. We love reading them to our kids. But somehow they don’t injure most of us. We grow up somehow understanding that we won’t all be saved by the Handsome Prince because we left our glass slippers at the counter at the 7/11. But Fed Tales are dangerous and subject us to very poor forecasts that can lead us into making very poor decisions. Yes, honey Ms Yellen is going to raise the rate by 20 points this year. No honey – rates will not rise by 21 points this year. Don’t worry your little ahead about that.

Let me make two points to support my lunacy. The first point has to do with what actually determines interest rates. Let’s call that point theoretical. Snore. The other one has to do with reality – looking at the data. Last week I presented inflation data. This week I look at interest rates.

Because some of you are already sleeping in your Lucky Charms, I will make the theory part less than the 1000 pages it deserves.  Any self-respecting economics textbook explains that interest rates are determined by the interplay of saving and investment. Whenever saving exceeds the needs for investment, market forces push interest rates downward. On another day when saving is insufficient for investment needs, rates rise to ration out the scare supply of funds. Point: interest rates are generally driven by private sector decisions.

With the US economy expanding and expected to expand even more it is natural that investment and interest rates will rise. Notice that the above story about simple supply and demand says nothing about the Fed. So let’s add them into the story. In times of a weak economy investment demand is low and rates fall. But sometimes they don’t fall enough to quickly resuscitate spending. Thus the Fed adds more money into the equation. This amounts to adding artificial temporary savings to the market and this action pushes market rates even lower.

When the economy starts to expand, investment and interest rates will rise with the economy. If the Fed is a worrywart they believe that the rising rates will prevent the economy from expanding and they pour in even more money thus keeping rates down. 

The Fed can keep doing this as the economy builds momentum but notice that their policy amounts to keeping a heavy hand on the lid of a rapidly bubbling pot. As the temperature rises what do you think will happen to the lid when the Fed lifts its hand? Yup – it will pop up. The longer the Fed holds its heavy hand on the lid – the higher the lid will eventually fly.

Interest rates rising is just like the lid rising. The longer Ms Yellen holds interest rates down the more thrust is building to push interest rates up. She thinks she can hold her hand on the lid a wee bit longer. She believes rates will then rise gradually.What if she is wrong? The below graph proves nothing but is illustrative. 

Below is a graph of the Federal Funds Rate. The FFR is the rate that the Fed directly controls through its policy instruments. Other rates, like government bond rates or mortgage rates seem to go up and down with the FFR. So when the Fed changes the FFR it often affects many or most rates.  The shaded areas are all the US recessions since 1970. 

I am sure the Fed never said anything like this -- yes we are starting to let the FFR rise and we hope it will begin slowly and then take off like a rocket until it causes a recession. But history does not lie. Except for the last recession (2008/2009) which was caused by a housing and financial crisis, virtually every recession followed a time period in which the FFR rose much more than just a little bit. Rates rose before 2000 or before the dot com crisis -- but that one is less clear than the previous recessions. Typically interest rates do not rise gradually. Ms Yellen is telling a tale that's as slippery as a bar of soap on a bathtub floor.