Markets, Not Janet Yellen, Should Set Interest Rates
By Richard Ebeling
Financial markets in the United States and around the world are all waiting with “bated breath” for when the Federal Reserve modifies its “easy money” policy and starts to raise interest rates. No one, however, asks a simple question: Why is the American central bank in the interest rate setting business?
In May 20th, the minutes were released of the April 2015 meeting of the Open Market Committee (OMC) of the Federal Reserve. The Open Market Committee decides when and by how much America’s central bank should intervene into the financial markets to influence the amount of money and credit in the banking system and, therefore, over time, in the U.S. economy as a whole.
The members, it seems, were still divided as to whether or not the OMC should start nudging interest rates up through monetary policy, or keep them at the low levels they have been at for years, with a majority leaning to not doing so until maybe September.
In its usual ambiguous language, the published summary of the OMC meeting stated that, “Many participants . . . thought it unlikely that the data available in June would provide sufficient confirmation that the conditions for raising the target range for the federal funds rate had been satisfied, although they generally did not rule out this possibility.”
The next day, Friday, May 21st, Federal Reserve Chairwoman, Janet Yellen, spoke before the Greater Providence Chamber of Commerce in Rhode Island and said she, “Thinks it will be appropriate at some point this year to take the initial step to raise the federal-funds rate target and begin the process of normalizing monetary policy.”
But she added that, “The Fed’s objectives of maximum employment and price stability would best be achieved by proceeding cautiously.”
How the Fed Creates Money and Influences Interest Rates
A key Federal Reserve policy instrument or “tool” is, as Yellen stated, the Federal Funds rate. This is the rate of interest that banks charge each other for overnight or short-term borrowing.
Every bank is required under Federal Reserve rules to maintain a certain amount of cash reserves against its outstanding depositor liabilities. On a daily basis, sums of money deposits flow in and money withdrawals flow out of every bank and financial institution. Sometimes banks find that the withdrawals have exceeded deposits into their vaults, and they are threatened with temporarily falling below that required minimum of cash reserves. At other times, the reverse may be the case, and deposits have exceeded withdrawals resulting in “excess reserves,” that is, those above the minimum required.
Banks borrow and lend funds between each other to cover and smooth out these temporary fluctuations in their deposit and withdrawal flows of cash, and a rate of interest emerges on the market reflecting the availability or “tightness” of such excess funds for some banks to lend to others running a bit short, short-term.
The Federal Reserve can influence this Federal Funds interest rate by purchasing or selling U.S. government securities. The Federal Reserve is prohibited by law from directly lending to the U.S. Treasury. The Treasury first borrows money to cover the government’s budget deficit by issuing IOUs – short-term or longer-term securities – to financial institutions or larger private lenders.
The Federal Reserve then goes into what is called the “secondary market” and offers to buy some of those securities being held by financial institutions or individuals, and pays for them by creating new money that then enters the banking system when those who have sold those government securities to the Federal Reserve deposit the check payments into their bank accounts.
The banks receiving those additional deposits of this new money now have larger excess cash balances with which to extend loans (after setting aside a small fraction as a required cash reserve against the depositor’s newly deposited money).
Finding themselves with larger available funds to lend, banks with try to attract interested and willing borrowers by lowering the rates of interest at which they offer to lend, given such things as the potential borrower’s creditworthiness and the type and term of the loan.
This includes the short-term Federal Funds rate at which banks are lending to each other. Money is said to be “easy” when the Federal Funds rates is low or falling, since this means the banking system is awash with cash to facilitate the reserve requirements of those banks briefly short of required reserves.
This process is reversed when (or if) the Federal Reserve sells government securities rather than buying them. The purchasers of those Treasury securities from the Federal Reserve’s portfolio pay for them out of their bank accounts. This “drains” reserves out of the banking system, tending to push up interest rates, as funds for lending purposes (all other things remaining the same) are reduced...
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