How Will The Federal Reserve Raise Interest Rates?

 |  Includes: IYF
by: John M. Mason


The Federal Reserve continues to taper its security purchases.

Within the Fed further discussions are taking place with respect to how interest rates might be raised in the future.

The Fed has already been experimenting with the use of reverse repurchase agreements as a tool to smooth the transition to a "more normal" functioning of the banking system.

This is a question the Robin Harding briefly examines in the Financial Times. The concern is growing… and will continue to grow in the coming months.

As reported in the article, the Fed "debated these tools at its April meeting and instructed the New York Fed to step up tests on a range of experimental facilities."

The Federal Reserve is looking at "tools" to raise interest rates because the financial markets are not experiencing enough demand for funds relative to the supply of funds to warrant increases in interest rates.

Although the effective Federal Funds rate, the interest rate the Fed targets for executing monetary policy, has been as high as 20 basis points during the time the central bank has been exercising its efforts of Quantitative Easing, over the past year the effective Federal Funds rate has fluctuated around 10 basis points.

On May 28, 2013 the effective Federal Funds rate was 9 basis points and on May 28, 2014 the effective Federal Funds rate was 9 basis points. In between the rate got as high as 12 basis points and as low as 6 basis points, but it never got outside of this range.

There is essentially no demand pressure on the effective Federal Funds rate to rise. Usually at this time in the business cycle, almost five years and counting, the demand pressure in the market is causing money market interest rates to rise.

Not this time! And, why should interest rates rise? The commercial banking system has almost $2.7 trillion in excess reserves, on which reserves member banks are receiving a risk-free 25 basis points. Certainly better than making risky business loans or risky mortgage loans where the spread the banks earn are not a whole lot better than this 25 basis points. Plus, the banks don't have to put up with the criticism of regulators about the loans that they are making.

So why should the commercial banks be lending?

The point of the Harding article seems to be that if short-term interest rates are going to rise in this extremely weak business recovery, it is going to have to be the Federal Reserve that causes the interest rates to rise.

Not a lot is going to happen, however, in the current environment as the Federal Reserve continues to "taper" its monthly purchases.

Over the last four-week period ending May 28, 2014, the Federal Reserve added a "net" $35.7 billion to its securities holdings. This is consistent with what it said it was going to be doing.

This increase is "small potatoes" compared with the "net" acquisitions over the past 52-week period, which was almost $950 billion.

One should note that this "net" amount of new securities added to the Fed's portfolio was a little greater than the whole Fed balance sheet before the financial crises began.

But the Fed, over the past year, has been practicing its "exit" moves in the repo market. Harding reports that the most practical method of raising the effective Federal Funds rate is what it calls the "Overnight Fixed-Rate Reverse Repurchase facility"…or, ON RPP.

Well, as I have reported over the past four months, the Fed has been executing Reverse Repurchase Agreements. One must be careful with this title because the reverse repurchase agreements must be interpreted from the side of the government securities dealer and not from the side of the Federal Reserve.

The Federal Reserve is selling securities to a government securities dealer under an agreement to repurchase the securities at a given future date under a set price. By selling the securities the Federal Reserve "reduces" bank reserve balances.

The objective of these "reverse repos" is to reduce the bank reserves that are in the banking system and this could cause interest rates to rise.

At the close of business on May 28, the Federal Reserve had over $170.0 billion in reverse repurchase agreements on its balance sheet. On May 29, 2013, the Fed did not show any reverse repurchase agreements on its balance sheet. Over the past 13-week period the Fed added slightly more than $40.0 billion in reverse repos to its balance sheet so it is obvious that this exercise has been going on for a fairly lengthy time.

In terms of what is happening in the monetary statistics, the same old story applies that I have been reporting over the past four years. Demand deposits at commercial banks are continuing to rise at a fairly rapid rate -- they are up almost 16.0 percent from last year but this increase in demand deposits is not coming from lending activity in the commercial banking system.

The major reason that demand deposits are increasing so rapidly is that individuals and businesses are still transferring funds for low-yielding short-term assets into demand deposits. As I have argued before, this is not a sign of strength in the economy, but an indication of the weakness that still exists. Of course, people and businesses are receiving next-to-nothing in interest rates on their "savings" but it is also true that because of the sorry economic state of so many economic units, these economic units want to keep their funds ready for spending, so they keep moving funds to "transactions" accounts.

Furthermore, the rate of increase in currency holdings continues to be historically high. Year-over-year, the rate of growth in currency in the hands of the public is almost 8.0 percent.

Small deposits at commercial banks and thrifts are down, year-over-year, at a 12.0 percent rate. The growth in retail money funds is basically non-existent for the past year and the growth in money in institutional money funds is down for the year.

So, "tapering" continues and officials at the Federal Reserve wonder how they are going to raise interest rates in the future when the time is right. And there still is the major question of what the Federal Reserve is going to do with the $2.7 trillion excess reserves in the banking system.

The answers to all these questions are crucial to the future of the United States economy. That is why it is important to keep a close watch on what the Federal Reserve is doing… and what its officials are thinking. Again, we are in completely new territory.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.