The Time Is Near: How Will The Federal Reserve Raise Interest Rates?

by: John M. Mason


The Federal Reserve is about to end its "tapering" of securities purchases.

Federal Reserve officials are debating about when interest rates should be raised.

The other real question is "how" will interest rates be raised.

Well, it looks as if the time is getting near when the Federal Reserve is really going to have to deal with raising interest rates.

Jon Hilsenrath writes in the Wall Street Journal, "Fed's Rate Debate Looks to Heat Up."

The Open Market Committee of the Federal Reserve System meets this next week. They are expected to reduce the rate at which they purchase more securities from $35 billion per month to $25 billion. This "tapering" is supposed to get the Fed out of the systematic bond purchasing game in October.

But, the next stage in the Fed's program appears to be the raising of short-term interest rates.

There are two questions related to this effort. First, when will the Fed begin to raise interest rates? Second, how will the Fed begin to raise interest rates?

Janet Yellen, Chairwoman of the Board of Governors of the Federal Reserve System, gave the impression in testimony before Congress said that the "when" question would depend upon the state of the economy. The Fed, she implied, did not want to move before officials believed that the economy was on sound enough footing that it could take a rise in short-term interest rates.

Many analysts believe that the Fed will start to move rates upward around the middle of 2015.

The unemployment rate has fallen faster than anyone was predicting and some analysts are seeing signs that inflation is picking up modestly. The real question seems to be whether or not the economy is starting to pick up some acceleration.

The second quarter GDP figures will be released on Wednesday, so the Fed should get a little look at these numbers before releasing their actions.

But, there is still debate between officials at the Fed concerning what actually is the health of the economy and when, given the movements in the economy, the Fed should act. There probably will never be a clear answer to this until…perhaps…it is too late. That is, the Fed waits too long.

The second question, however, is gaining more and more attention.

The banking system appears to have almost $2.8 trillion in excess reserves!

The issue is, how can short-term interest rates be made to rise with so much liquidity washing around the banking system?

And, it appears that there has been little or no demand for short-term funds in the money markets as the effective federal funds rate has been below 0.10, below 10 basis points for much of this year and has been nowhere near the peak of the Fed's target range for almost the full time that the quantitative easing has been taking place.

It seems absurd to think that the Federal Reserve will take sufficient reserves out of the banking system as it now stands so that there will be a sufficient lack of "supply" to cause the federal funds rate to rise.

Another tool that has been re-introduced into the Fed's toolbox is the use of repurchase agreements. On the Fed's balance sheet any actions of the Fed to reduce the amount of reserves in the banking system shows up as "reverse repurchase agreements." In this activity, the Federal Reserve is selling securities under an agreement to repurchase them after a short time. This is a reverse repo from the standpoint of the securities dealers the Fed is transacting with. The Fed has just always accounted for them in this way.

The Federal Reserve began testing the "repurchase" market with securities dealers last year and on Wednesday, July 24 had a little less than $140 billion of them on its balance sheet. So, the Fed has been working this market again for a sufficient time so that the private sector is accustomed, once again, to feel the Fed's presence.

Note, that all during the quantitative easing the Federal Reserve was constantly engaged in "reverse" repurchase agreements…it was just with "foreign official and international accounts." This line item on the Federal Reserve's balance sheet has remained around $100 billion or more for much of the last five years.

There are some questions about how effective this tool might be in raising short-term interest rates. After all, repurchase agreements, by their very nature, are just short-term reductions in the securities portfolio. The Fed would have to engage in outright sales of securities to "permanently" reduce the size of its portfolio.

Furthermore, there are other issues connected with the use of reverse repurchase agreements in the Fed's effort to raise interest rates. Sheila Bair, former chairwoman of the Federal Deposit Insurance Corporation (FDIC), had an op-ed piece in the Wall Street Journal this past week. The subtitle ran: "The mere existence of this central bank program could exacerbate liquidity runs in times of market stress."

Seems as if the bottom line is that the American economy is approaching a time when short-term interest rates are going to need to be raised. However, the problem that has not been solved is how the Federal Reserve is going to accomplish this task.

An easy solution would be for the economy to begin to grow fast enough or the rate of inflation would pick up sufficiently to cause the demand for money to rise enough to put upward pressure on these short-term interest rates.

However, at present, I am not betting on this.

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