The Central Bank of the United States, the Federal Reserve, announced last week its first interest rate rise since September 2018, signalling a change in the Fed’s Monetary Policy. The rate rise was 25 basis points or 0.25% to 0.5%
The Federal Funds rate is the lending rate that the Federal Reserve gives to its borrowers, which are mainly banks and other large financial institutions, another name for the Federal Fund rate is the Interbank rate, which is the interest rate that banks and other financial institutions give to each other.
This brings us to how Monetary Policy works behind the scenes. Since the start of the pandemic, prior to the current rate rise, the Federal Reserve kept the Federal Funds rate at near 0 basis points. As such, when the Federal Reserve directly lends money to banks and Financial Institutions, these banks receive this at a lower cost. Because of this, these financial institutions can then pass this rate decrease onto consumers and other borrowers, thus making loans such as mortgages cheaper, which was one main contributor to why out of all markets, housing performed excellently during the COVID-19 pandemic.
At the same time, the Federal Reserve implemented Quantitative easing measures of $8.91 trillion as of March 8, 2022. Please note that we use the term Quantitative easing lightly, as, rather than using Open Market Operations, the Federal Reserve can and does lend directly to banks and financial institutions. This is different from traditional Quantitative. Traditional Quantitative easing goes like this. During a recession, Keynesian Economics states that the government should begin spending more to fill the gap in aggregate demand, as a rise in government expenditure can help boost the economy and yield economic growth. This typically leads to governments overspending their budgets, evidenced by the US national debt reaching $30 trillion dollars. Yet, this money must have come from somewhere. As such, when governments need to borrow, they issue bonds, which are essentially contracts stating that the buyer will lend the US government a specific amount of cash at a certain interest rate. When the US government releases these bonds, large financial institutions, such as banks, pension funds, brokers, etc, purchase these bonds. When the purchase occurs, the US government receives an initial injection of cash to continue spending, then, in the long run, the US government begins to repay the interest on these bonds to its lenders. This makes government bonds very attractive for financial institutions. The interest earnt from them, although low, is seen as a pretty much guaranteed investment opportunity as it is highly unlikely for the US government to default on its debt, even though it is at $30 trillion. As such, because financial institutions begin to lend all of their money to the government because of how safe it is, there is now no more money available for other borrowers, such as other banks, or, us, the average consumer.
This is where Quantitative easing comes in. The Fed creates money and then uses this newly created money to buy back bonds from Financial institutions, this then means that the Financial institutions get an injection of cash to lend out to other lenders. At the same time, because the Fed now owns the government debt, the debt is now owed to the Federal Reserve, meaning that over time, the initial borrowed amount and debt repayments will be repaid to the central bank. Once this occurs, the money is now out of circulation, it will never make its way back into the economy unless the Federal Reserve wants to, meaning that in the long run, this process of creating assets and liabilities eventually leads to a contraction in the money supply.
Anyhow, in the present, this process of using QE or other forms of expansionary Monetary Policy such as direct lending leads to an increase in the liquidity of financial institutions. This essentially means that they can continue to lend out to other borrowers, which is incredibly important for an economy as the end of borrowing essentially, in an extremely paraphrased way, means the end of an economy. More importantly, continued borrowing, at a cheaper cost, helps the Federal Reserve achieve its 2.0% CPI inflation target as cheaper borrowing combined with a cheaper cost to service debts increases aggregate demand, yielding demand-pull inflation.
However, it seems that the Federal Reserve has been unsuccessful at meeting this target as the current US inflation hit a new 40-year high of 7.9% last month, an increase from 7.5% CPI in January. As such, in an effort to taper inflation rates, the US Federal Reserve has raised the base rate to 0.5% to reduce aggregate demand as this move of Contractionary Monetary Policy will make it more expensive to borrow and to service debts for economic agents.
Yet, it is unlikely that this rate rise will work to taper inflation for many reasons. The first reason is that the majority of liquidity that was gained as a result of the Federal Reserve's Expansionary Monetary measures was eaten up by the Financial Market. This means that rather than going into the pockets of consumers and businesses, the $8.91 trillion created by the Federal Reserve was instead placed into speculative markets such as the stock market as Financial Institutions looked for short-term profit maximisation, a pattern that has led to the S&P 500 performing at the highest level it has ever been at in history despite the fallout of the pandemic. The other reasons are in relation to the interest rate rises and how interest rates actually work. First off, it is unlikely that a 0.25% rate rise will have any real effect on aggregate demand levels as such a change will only have a slight effect on the cost of servicing debt as well as the cost of borrowing itself. Yet, the second main reason is that the interest on loans is either fixed or variable, as such, economic agents on fixed-rate loans, such as a mortgage will see no change in debt servicing costs. And, consumers on variable-rate mortgages are, as previously explained, unlikely to feel any real change at all.
So, why has the Federal Reserve even bothered with the rate rise? Well, the likely reason is to instil confidence in the economy as well as Financial Markets. During the Federal Reserve’s announcement, the central bank's chair, Jerome Powell, announced that the Fed does not expect a recession to occur, thus using forward guidance to show Financial Markets that confidence should remain high in the coming months despite incredibly high oil prices. At the same time, Jerome Powell used the opportunity to showcase the Federal Reserve's dot plot, which illustrates the outlook for interest rates as shown below.
This opportunity allows the Federal Reserve to utilise forward guidance to show economic agents what the plan for the future will be regarding interest rates. This move is unlikely to affect the inflation rate as it currently stands and is more used to achieve the Federal Reserves' other goal, that being ensuring that Financial Markets are stable as such an announcement ensures that financial companies are prepared for future rate rises. This means that the current price of stock market indexes such as the S&P 500 will reflect the future rate rises, making them ‘priced in.’
At the same time, Jerome Powell stated that the Federal Reserve will slowly begin its program of Quantitative Tightening as the Federal Reserve's balance sheets will begin reducing in the coming months to take money out of the economy, a move which once again is designed to ensure that Financial companies are not shocked by the Federal Reserve’s decision making. Yet, the main question that remains is whether the Fed’s policy change has come too late. An answer to which we will find perhaps in the coming months or years as it is difficult to tell in the present whether the Fed’s decision to put the brakes on inflation will be effective in halting the current spiral.
Written by Hubert Kucharski