Will the Federal Reserve Lose Control of Interest Rates?

Is it time to panic yet?

Hmmm…

From the Wall Street Journal

For the first time in more than a decade, the Federal Reserve Bank of New York took steps Tuesday to relieve pressures that were pushing short-term interest rates higher than the central bank wanted. 

Strains developed Monday in short-term financing markets that suggested the central bank could lose control of its federal-funds rate, a benchmark that influences borrowing costs throughout the financial system.

Bids in the fed-funds market on Tuesday morning reached as high as 5%, according to traders, well beyond the central bank’s target range, which is 2% to 2.25%. 

The Fed moved Tuesday morning to put $53 billion of funds back into the banking system through transactions known as repurchase agreements. The New York Fed said the effective fed-funds rate, or the midpoint of transactions in that overnight market, stood at 2.25%, up from 2.14% on Monday.

This may be nothing more than a minor blockage in the plumbing of the global financial system…or it may be a very big deal.

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Put simply, there doesn’t appear to be enough cash in the system. This is why the short-term market interest rate shot up higher than the Fed fund rate (the official interest rate set by the Federal Reserve).

How can there not be enough cash in the system, you may ask? Don’t central banks just create cash at will…print it out of thin air?

Yes and no.

In order for a central bank to create cash and put it into the banking system, they need to purchase an asset. It comes back to double-entry accounting.

The way the Fed, or any other central bank, injects ‘liquidity’ (cash) into the system is by usually buying government securities from banks.

During the crisis of 2008 and 2009, the Fed also bought billions of dollars of mortgage-backed securities from the banking system. In doing so, it effectively swapped a dead asset sitting on the banks’ balance sheet, for cash.

The asset was ‘dead’ because during the property bust the value of the underlying property was well below the value of the securities.

This is how the Fed ‘bailed the banks out’.

Anyway, the point is the Fed is the lender of last resort, and the buyer of last resort. It injects cash into the financial system by buying assets from the banks.

This cash then flows around the financial system. In normal circumstances, at the end of each day, depending on the billions of customer transactions undertaken, some banks have excess cash and some have a shortage. The banks with excess sell it to the ones with a shortage at the overnight rate, or the official ‘Fed funds rate’.

If there is plenty of it, the price of cash (the interest rate) is low. If there isn’t enough of it, the price (interest rate) increases. This is the rate that the Fed manages day to day.

But since the Fed intervened in the 2008 crisis, there has always been excess cash in the system. This excess cash is deposited back into the Federal Reserve banks. That is, it is not needed by the commercial banking system.

In recent years, the Fed has started the slow process of draining this excess cash from the system.

According to the latest data, in the 12 months to 12 September, the Fed took US$464 billion in cash out of the financial system. In the week to 12 September, US$30.7 billion in cash disappeared.

In other words, the buyer of last resort is shrinking its balance sheet by selling assets back into the market for cash.

At least it was.

The flare up in interest rate markets overnight, coming just ahead of the Feds expected decision to lower the funds rate tomorrow is ominous.

What it’s saying is that the Fed will never be able to ‘normalise’ its balance sheet. The economy is addicted to credit growth. The Fed must feed this addiction or watch liquidity dry up.

You know as well as I do that it’s not going to sit back and watch liquidity evaporate and interest rates increase.

It’s therefore only a matter of time before the Fed starts expanding its balance sheet again. We’re in the midst of a global slowdown. The Fed will have to pick up the slack.

It will resort to buying treasuries again, indirectly financing the US government deficit, which will reach more than US$1 trillion this year and for the next few years to come.

At what point this starts trashing the dollar is hard to tell. Every other central bank is trashing their own currency, so it’s a relative game.

But the message is this: I wouldn’t panic about the jump in interest rates. The Fed will put that fire out pretty quickly. It will destroy its credibility and currency before it loses control of interest rates.

But it may lose control of, say, the gold price or stock prices. That would be interesting.

Regards,

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Greg Canavan,
Editor, The Rum Rebellion

PS: There’s a BIG surprise coming for the AUD in 2020. Click here to find out what it is (free report)


Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own. Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts. At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates. Greg will help The Rum Rebellion readers block out all the nonsense and encourage personal responsibility…both in the financial and political world.


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