Janet Yellen and several of the Federal Reserve board members have been talking about raising the interest rates charged by the Federal Reserve Bank. The Fed Funds Rate is that rate of interest set by the Federal Reserve Board and is used in determining the rate charged by the banks that have surplus deposits in their Federal Reserve accounts that they may loan to those member banks who are essentially short of funds in their depository accounts at the FED. Ah, you were thinking that the FED set the mortgage interest rates and credit card rates and Treasury Bond coupon rates. Only indirectly. Each member bank (BofA, Chase, Wells Fargo, etc) must buy a share of stock in the Federal Reserve Bank and must hold a specified percentage of its capital on deposit with the FED. These reserve deposits are specified by law and for several decades have been a lower percentage, meaning that the bank could lend more of its capital. The reserve functions as a hedge or security against insolvency.
So why should it be a big deal to raise or lower the FED rate? Banks are, in parlance of the economics of Adam Smith and those who followed in the 18th century, rent seekers. In England the nobility and a number of the non nobility or general population owned land. What we have come to know as share cropping was the norm for a great many farmers in England and Scotland. The great estates owned by a local noble would rent out various plots of land including the housing. One could pay hard money or a set amount of the crops harvested. Often equipment and draft animals were shared or rented by those who lacked such equipment and animals. So the local noble drew income from renting land to the farmers and this activity was called rent seeking. This carries over into the modern world where those who have money or capital live off the interest gained from “renting” their capital in the form of loans. These loans may be bonds, mortgages, or any other type of investment that specifies some income for the owner of the capital. Banks use their capital to make money or profit for the bank. The banks also use the deposits of those who deposit money in the form of savings accounts, checking accounts, and other types of services. Banking is a fluid business in terms of money. Some days one may have a surplus of cash and other days a shortfall. The books must be balanced every night and thus, depending on surplus or shortfall, one can loan or borrow money accordingly. The higher the interest rate on these exchanges to more profit or expense a bank gathers. Since the amounts are often in the multiple millions of dollars range, this rate is a big deal. And the rate is not uniform. One bank may charge another bank a higher rate than that set by the FED.
Now we might ask why should there be a shortfall at the end of the day? Ah, profit maximization. Banks want to keep every penny busy earning interest. In a way, this interbank overnight lending is a fiction in the age of electronic funds transfer. No bag of cash ever trades places. But the practice is real enough as one either earns a profit or pays a penalty on one’s deposits or lack of deposits. A number of bonds may mature and the bank’s capital increases. A loan may default and the capital decreases. Company payrolls are deposited one day and at the end of the week withdrawn. So the FED rate is the risk premium one pays or earns for doing business. If that premium increases, then the other rates must increase to reflect that risk. If I can borrow at one percent the money I need for short term investment or speculation, then I can invest or speculate on the small difference in daily stock or bond or even foreign exchange values. We call this the “carry trade”. I could buy short term contracts that pay me two percent on the money I borrow at one percent. But if the rate increases to two percent then it become a little more difficult to find someone willing to borrow at three or four percent. As the cost and risk increases, the less likely I will be able to use the bank’s money to make money for myself in the secondary lending markets. This FED rate also affects the margin rates for the stock markets, the commodities exchanges, and even the bond markets. Thus, raising the FED rate decreases speculation through higher risk and cost premiums. Lowering the FED rate increases such speculation. Unfortunately most economists don’t seem to understand this effect. You would think it simple enough to understand. True, many businesses will find the rates very attractive for capital expansion as well and mergers and acquisitions. But such activity may not lead to increased consumer spending nor increased hiring.
This cheap money situation has led to many different financial bubbles over the centuries. William Jennings Brian was the populist political reformer who decried the “hard money” policies of the Eastern Bankers before the turn of the century before last. So much of the land owned by the Federal Government in those territories that would later become states in the western plains was sold at very cheap rates per acre or even homesteaded. People weren’t buying a quarter acre and a house, they were buying farms. And as farms failed because the prairie was a hostile place to grow crops due to the lack of dependable sufficient rain, they were resold to those with either ready cash or the ability to procure a mortgage. Often the resales were bought for far more than the land was worth, that is, the cost of raising crops. This farm land boom and bust played out in many areas and over many different decades. The dollar was backed by the gold standard and gold had been plentiful when the gold fields of California were producing. But when that production declined, gold became more scarce. Silver came into the market but because its supply exceeded that of gold, it carried a lower premium in exchange as a money. Thus, as silver became the medium of exchange in the west, it bought far less than gold and banks would not readily accept silver in payment or demanded a stiff premium in its acceptance. Of course this money issue follows periods of inflation and deflation and depression. When money is cheap we over borrow, when it is dear we have a hell of a time paying it back.
The FED rate affects the coupon rate or interest rate of Treasury Bills, Treasury Notes, and Treasury Bonds. It affects the corporate bond coupons, the corporate notes, and other corporate borrowing. And it affects housing mortgages, automobile loans, home improvement loans, lines of credit, and other consumer borrowing. And it also affects the rates of personal savings. If the best I can get for my passbook savings account is one percent of one percent, well, that certainly doesn’t keep up with inflation. I have to find somewhere else to put my money. I chase higher yield and thus higher risk of losing my savings. The community of economists in this country and indeed, the world, often fail to understand that consumer savings is the engine for capital formation that allows economic growth. Capital does not appear out of nothing. All capital originates out of savings. That includes corporate profits and personal income. Retained earnings is savings which becomes capital. When I can earn interest or rent on my personal savings, when I can take my retained earnings from my business and use those earnings to buy more capital assets (buildings, machinery, and so forth) then I am investing my savings. I am expanding the capacity of the economy to produce goods and services. Now it should be noted that our current GDP measures consumption and that is not exactly the best way to measure economic growth. But that’s another subject for another time.
But the rise in the FED Funds Rate also affects foreign economies. The multinational corporations, the multinational banks, the multinational finance, these are indirectly affected by the FED Funds Rate. If general interest rates rise in the US, then foreign money flows into this country and out of those other countries. This is investment chasing yield cross boarder. The effect of capital outflow to a country is to cause economic problems. Loans become harder to obtain, government bond yields rise. You know, the Standard and Poor’s rating for Europe had dropped, meaning that the premium for borrowing increased. If the FED raises rates to one percent that is enough to tip Europe into a general depression. Raise the rate to two percent and the rest of the world goes to hell in a hand basket. So far, Yellen has only talked about a quarter percent rise, but the closer the Fed comes to one percent the more havoc is sent through the financial jury rigging that we have known so long. The cost of our own borrowings will rise significantly. Since the federal government depends of deficit spending the cost of that spending will rise significantly. And as the FED raises rate, it will force the ECB and the Bank of England to respond with raises of their own. Of course the other problem is that all of the quantitative easing the FED had done will come back to bite it in the ass. The theory behind QE is that it creates economic growth. This is the big lie for it does no such thing.
Quantitative Easing, as done by the Federal Reserve only gave money to those who had assets. First the FED bought a lot of Treasury Bonds and Notes. Who owned these bonds and notes? Banks and investment firms. What did they do with the money? The chased yield down the street at considerable risk. The the FED bought MBS, mortgage backed securities, better know as piles of mortgages lumped into a investment vehicle and sold as a type of bond. Unfortunately many of the mortgages represented real estate that is not worth the mortgage, the mortgage may be in default, or it may even be a fraudulent mortgage. The FED does this in terms of repurchase agreements. The institution they buy the MBS and bond assets are pledged to repurchase them in the future. But the question is, at what price? The Federal Reserve balance sheet or account is pushing four trillion dollars in MBS, Bond, and other assets. If it raises interest rates then it will suffer losses. If it starts the buyback process then the economy will stall as money is removed from the banks and investment institutions. The stock market will collapse, literally. A quarter percent isn’t much and will have a limited effect, but it will have an effect. Once the FED goes beyond that point, we slide quickly into a depression as the various bubbles burst. The FED is literally between a rock and a hard place and between the lowering of interest rates to near zero and the multiple issuing of QE, it has nowhere to hide. For us peons, it would matter much, life goes on. For the one percent, it matters allot as their wealth is tied up in the economic mess of loans, bonds, derivatives, and other “assets”. Sure, some of them have bought gold, but when was the last time you tried to buy groceries at the store with a bar of gold? It’s not currency, it’s not fiat money. Someone else must want to buy that gold bar and pay in the accepted currency. The big boys are about to discover when an asset is no longer an asset.