Why Are We Speculating About When The Fed Will Raise Rates When The Real Issue Is How – Revisited

The Wall Street Journal raised this issue today, so I am recycling a post I wrote back in March, which itself was a rehash of thoughts I had expressed before. This will be timely until it isn’t, which will be when the Fed actually does try to raise rates, and either proves my skepticism correct, or wrong. 

March 17, 2015 – Back in the good old days the Fed more or less controlled interest rates by keeping reserves tight and by adding or removing reserves daily, mostly via its open market repo operations. The Fed would announce a target rate for Fed Funds, and the market would trade around that rate because the Fed could make these daily adjustments to the cash in the system, tightening or loosening the market as needed day to day.

But today there are $2.8 trillion in excess reserves on its balance sheet. Those reserves are the banks’ cash assets that are on deposit at the Fed. It’s the banks’ cash. They can do what they want with it. They usually buy short term paper or maybe bonds or even stocks. But it’s always there sloshing around the banking system, as noted on line 34 and footnote 21 of the Fed’s H8 weekly statement on the US banking system. It circulates around from bank to bank, or to and from the US Treasury to the banks, but it never leaves the banking system. So the Fed can’t manipulate the market by fiddling with reserves as it once did.

Apparently the Fed’s new method of raising rates will be to wave a magic wand, say “Abracadabra, rates go up!” and rates will magically rise just because everybody believes that the Fed is the great and powerful Oz. Now that might work for a little while, but all that excess cash will still be out there in some form, and I think that anyone who thinks that banks won’t bid aggressively to make loans or buy short term paper is kidding themselves. There might be a published official Fed rate of one kind or another that’s 25 basis points higher than before, but in the real world, unless that excess cash begins to be removed from the system, actual market rates at which banks transact actual bidness probably won’t rise much, if at all.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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