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Economics. Explained.  

Category » Federal Reserve

Fed Funds Rate

May 9, 2017

The federal funds rate is the overnight rate that banks charge each other to borrow/lend  reserves.  Some banks have more reserves than they need.  Others (principally large banks) are short of reserves and must borrow from other banks in the system, typically on an overnight basis.  The rate at which this borrowing takes place is known as the fed funds rate.  It is the only rate that the Fed can directly control.  Most other short-term interest rates like Treasury bills, CD’s, commercial paper, etc. are very closely linked to this rate, so when the Fed tightens or eases all other short-term rates move in the same direction by essentially the same amount.

Once the recession began in December 2007 the Fed tried to stimulate the economy and ultimately pushed the funds rate almost to 0%.  It remained at that record low level until December 2015.

In December 2015 the Fed decided it was time to alter its policy and push the funds rate towards a more “neutral” policy stance.  So what might be regarded as a  “neutral” level for the funds rate?  The answer lies in the relationship between the funds rate and the inflation rate.  Whether an interest rate is high or low depends entirely on how it stacks up relative to the rate of inflation.  Think of it this way.  A 10% interest rate most of the time would be regarded as punishingly high.  But in the late 1970’s when the inflation rate was 12%, a 10% rate was actually quite cheap.  An investor could borrow at 10% for a year, buy an asset whose price would rise 12%, then pay back the 10% loan a year later and actually make money on the transaction.  So whether rates are high or low really depends upon their relationship to the rate of inflation.

The difference between the funds rate and the inflation rate is known as the “real” funds rate. Over the past 30 years, the funds rate has averaged 1.0% higher than the inflation rate.  As shown below, sometimes it will be higher than that, other times it will be lower.  But over time the “real” funds rate has averaged 1.0%.  Hence, the Fed would probably regard such a “real” funds rate as relatively “neutral”.  So if the Fed wants an inflation rate of 2%, and believes that its policy is neutral when the funds rate is 1.0% higher than that, then by implication is that a 3.0% funds rate in today’s world would be roughly “neutral”.

But the funds rate today is not at 3.0%, it is 0.75%.  Thus, the Fed has a long ways to go.  It typically would tighten by 1/4% every time it meets which is every six weeks.  This time, however, the Fed has indicated that intends to raise the funds rate at an even slower pace or, probably, about 1/4% every other time it meets which would be every 12 weeks.  If it tightens at this new super-slow pace it will take until mid-2020 for the funds rate to climb to the 3.0% mark.

The U.S. economy has never dipped into recession until the Fed has pushed the funds rate higher than the so-called “neutral” rate.   If that is the case, it is hard to imagine how the next recession will occur prior to 2020.

Stephen Slifer

NumberNomics

Charleston, SC


Federal Reserve’s Balance Sheet — Total Assets

May 9, 2017

The Federal Reserve’s balance sheet reflects the extent to which the Fed has been buying securities to support the economy since late 2008.  Prior to the recession, the Fed’s asset holdings were about $900 billion.  But then when the bottom dropped out, Lehman Brothers collapsed and the banking sector was on the verge of imploding, the Fed bought all sorts of securities in an effort to provide sufficient liquidity to the banking system to prevent a complete collapse of the financial sector.  Its balance sheet exploded from $900 billion to about $4.5 trillion currently.

Its balance sheet quickly rose from $900 billion in September 2008 to $2.2 trillion by the end of that year.

From the end of  2008 through the end of 2010 the Fed’s balance sheet then stayed relatively steady.  But at the end of 2010 the Fed decided that it was unhappy with the unemployment rate at almost 10% and it engaged in a second round of easing which as become known as QE2 (or Quantitative Easing 2).  They decided to purchase another $600 billion of securities which boosted its balance sheet to $2.8 trillion in an effort to push long-term interest rates lower, provide additional stimulus to the economy, and  (hopefully) push the unemployment rate sharply lower.

The third step in Fed easing occurred in September 2011.  They decided to sell $600 billion of Treasury bills and short-dated Treasury notes, and buy an equivalent amount of long-dated Treasuries.  By doing this “swap” the Fed did not further inflate its balance sheet.  The object was to push long rates lower and, hopefully, provide further stimulus to the housing market.  As a result the yield on the 10-year note fell to a record low level of 1.5% by the summer of 2012.

The fourth step in the Fed easing process came in September 2012 when the Fed indicated that it was not happy with the 8.1% level of the unemployment rate and wanted it to decline more quickly.  So to jump start the economy, the housing market in particular, it told us that intended to buy $40 billion of mortgage-backed securities every month until such time as the unemployment rate declined to a more acceptable level.  That was in addition to its monthly purchases of $45 billion of Treasury securities.  That means that the Fed further increased the size of its balance sheet which has climbed from $2.8 trillion in September 2012 to its current size of to $4.5 trillion.

But the economy progressed to the point where the Fed felt comfortable phasing out its monthly purchases of securities.  Indeed, it began to gradually trim its pace of buying securities from $85 billion per month ($45 billion of U.S. Treasuries and $40 billion of mortgages) at its peak in December 2013.  It cut its purchases by $10 billion at each FOMC meeting during 2014 and eliminated the program entirely by October of 2014.   The Fed has said that it does not plan to sell securities outright to reduce the size of its balance sheet.  But it does intend to gradually shrink it by allowing maturing securities to mature.  While it has not yet begun to do so it plans to begin that process by the end of this year..  Given that the average maturity of the Fed’s debt is about 10 years that process will gradually occur over a very long period of time.

Stephen Slifer

NumberNomics

Charleston, SC


Treasury Notes — 10-Year Maturity

May 9, 2017

The yield on the 10-year note backed up dramatically following the election in November of last year as market participants feared that Trump’s tax cuts and the repatriation of funds currently held overseas could push the inflation rate  higher and force the Fed to tighten more quickly than it currently anticipates.   The rate rose from 1.7% right before the election to 2.6%.  But it now appears that any stimulative effect from the policy changes will take place later rather than sooner and the yield on the 10-year note has dropped back to 2.25%.

The question arises, what is an appropriate level for the 10-year note?   The answer to that question lies in something called the “yield curve” which is nothing more than the difference between long-term interest rate and short rates.  Today the 10-year note is 2.25%, the funds rate (an overnight rate) is 0.9%, so the difference between long rates and short rates, or the yield curve, is 1.35%.

The steepness of the yield curve varies depends upon whether the Fed is tightening or easing.  When the Fed tightens it raises short-term rates (i.e., the funds rate) much more rapidly than long-term interest rates rise, the yield curve “flattens” and can even invert.  When it inverts it means that short rates are higher than long rates, and the spread is negative.  Frequently an inverted yield curve can be a sign that the Fed has raised rates high enough that a recession might not be too far down the road.  On the chart below the Fed tightening periods are the periods shown in white.  You can easily see how the curve flattens, and even inverts when the Fed is in tightening mode.  That is not the case today nor will it be the case for several more years.

When the Fed eases they lower short rates (the funds rate) much more quickly than long-term interest rates decline and the yield curve “steepens”.  Periods when the Fed is easing are shown in pink in the chart above.  Once again the steepening of the curve when the Fed is in aggressive easing mode can be seen easily.

When the yield curve got to 3.5% the Fed was aggressively pushing the funds rate lower.  That is not the case today, and has not been the case for 6 years.  With the curve at 1.35% currently it is probably about where it should be for now.

Between now and yearend both short- and long-term interest rates may move slightly higher as the Fed continues gradual move towards a higher funds rate.  We expect the yield on the 10-year note to rise as well. The yield on  the 10-year note will probably climb by an additional 40 basis points between now and yearend to 2.65%.

Interest Rates -- 10-year versus mortgages projected

Stephen Slifer

NumberNomics

Charleston, SC


M-2

May 4, 2017

Growth in the M-2 measure of the money supply  has slowed slightly to a 6.3% pace.

To know whether that rate is too fast or two slow, the Fed needs to look at the relationship between growth in the money supply and growth in nominal GDP.  Over the past 50 years the two have grown at almost exactly the same rate.  Or, to put that in econospeak, M-2 velocity is 0.0%.  Thus, if the money supply is growing at a 6.3% pace, then the Fed might expect nominal GDP to grow at that same 6.3% pace.

Unfortunately, it cannot determine how much of that growth rate will represent real GDP growth and how much will be inflation.  Typically, economists think that our economic speed limit, i.e., how fast the economy can grow without giving rise to inflation is about 2.0%.  So if real GDP grows by 2.0%, then the Fed might end up with an inflation rate of about 4.3%.  You will recall that their target for inflation is 2.0%.  Thus, the current pace of money expansion is  faster than the Fed would like over the longer term.   Having said that, all these numbers can be a little bit squishy and relationships change.  The point is that at the moment money growth is more than ample to support a vigorous recovery and may be pointing towards faster GDP growth, higher inflation, or both.

Stephen Slifer

NumberNomics

Charleston, SC


Excess Reserves

May 4, 2017

Banks must maintain a certain percentage of their deposits in an account at the Fed known as that bank’s “reserve” account.  Because they do not want to overdraw their account, prudent bankers always seek to hold just a little bit extra.  This little bit extra is known as “excess” reserves.  Prior to the recent recession that “little bit extra” added up over all the banks in the banking system, was a little bit less than $2.0 billion. During the recession when liquidity in the banking system dried up, the Fed essentially put the pedal to the metal and started stuffing reserves into the banking system right and left.  Its overriding objective was to get the economy moving again and, indeed, it succeeded.  The economy turned around in June 2009 which was sooner than many economists had anticipated.  But now the Fed has a problem.  Excess reserves in the banking system today are $2.2 trillion (with a T, not a B).  Those reserves represent funds that could be lent out by banks to fuel a spending spree the likes of which we have never before experienced.  They are, in some sense, “ammo” available to the banking system for lending.

Between the collapse of Lehman Brothers in September 2008 and the end of that year, excess reserves rose quickly from $1 billion to $900 billion.

At the end of 2010 the Fed decided that it was unhappy with the unemployment rate at almost 10% and it engaged in a second round of easing which as become known as QE2 (or Quantitative Easing 2).  They decided to purchase another $600 billion of Treasury securities at a pace of $45 billion per month, which quickly boosted excess reserves to $1.5 trillion.  The effort was designed to push long-term interest rates lower, provide additional stimulus to the economy, and  (hopefully) push the unemployment rate sharply lower.

The third step in Fed easing occurred in September 2011.  They decided to sell $600 billion of Treasury bills and short-dated Treasury notes, and buy an equivalent amount of long-dated Treasuries.  By doing this “swap” the Fed did not further inflate its balance sheet.  The object was to push long rates lower and, hopefully, provide further stimulus to the housing market.

The fourth step in the Fed easing process came in September 2012 when the Fed indicated that it was not happy with the 8.1% level of the unemployment rate and wanted it to decline more quickly.  So to jump start the economy, the housing market in particular, it told us that in addition to its purchases of $45 billion per month of U.S. Treasury securities, it also intended to buy $40 billion of mortgage-backed securities every month until such time as the unemployment rate declined to a more acceptable level.  That was in addition to the $45 billion of Treasury securities that it was purchasing every month.  As a result,  excess reserves have now climbed from $1.5 trillion to $2.7 trillion.

Thus, at its peak in late 2013 the Fed was purchasing $85 of long-dated securities every month — $45 billion of Treasury notes and bonds and $40 of mortgage backed securities.  The Fed began to slow its pace of purchases by $10 billion at every FOMC meeting during 2014.  It phased out its purchases of securities in October 2014

If the Fed allows all those reserves to be used, inflation would skyrocket.  Clearly, the Fed can not and will not allow that to happen. As it stands right now this is only a potential problem.  The reserves for the most part are simply sitting in the equivalent of a checking account at the Federal Reserve.  They are not boosting the money supply, they are not being lent out extensively to consumers or businesses.   They are not in any way inflationary.  Why?  Because until recently both consumers and firms were more interested in paying down debt than in adding to it.  During that period of time their income has been going up, their outstanding debt has been going down, hence their “debt burden” has become far more manageable.  Indeed, it is now well below what most economists would characterize as a “comfortable” level of debt.

But since the election loan growth has slowed to 4,1% recent growth has been virtually nonexistent.  It is apparent in all loan categories — commercial and industrial loans, real estate loans, and consumer loans.  This seems to have something to do with likely changes in bank regulations under President Trump.  Banks are being very cautious until some of this uncertainty is resolved.

 

 

It has a game plan on how it intends to eliminate the huge volume of excess reserves.  It can raise the rate of interest it pays to banks on their reserves account.  In that event, the excess reserves would still be there, but would effectively be neutralized.  Why lend money to you or me at 6% when banks can keep the money in their reserves account at the Fed, risk free at, say, 5%.  Indeed, he Fed has raised the rate it pays on excess reserves from 0.0%% to 0.75%.  It will continue to raise this rate slowly.  The Fed says it does not intend to sell any of its vasts holdings of securities, but it will allow some of its security holdings to run off as they mature.  If that is what it chooses to do it will take a long time, probably until 2022,  for the Fed to shrink excess reserves back to a more normal level.

But the real question is, will all of this work?  The Fed thinks it can pull it off.  But it is important to remember that they have never been in this situation before.  In the old days they might have to drain $2 billion of reserves.  Today they have to drain $2.2 trillion.  That is 1,100 times bigger than anything they have had to deal with in the past.  They may be successful, but the order of magnitude here creates the risk of unintended consequences.

Stephen Slifer

NumberNomics

Charleston, SC