The Fed Fears Rising Market Interest Rates
Donald Trump has not had an easy, straight-forward relation with the Federal Reserve. He has both claimed to be a low-interest rate person and accused the Fed of keeping interest rates too low for political reasons. He has also expressed regret at appointing Jerome Powell and the White House has even explored the possibility of firing or demoting the Fed chairman . Apparently, President Trump’s intention was that Powell was to keep interest rates low, and he is not at all happy with the Fed’s policy of allowing them to increase. But why, since the Fed is not immune to political pressure , has the central bank allowed rates to rise in the face of presidential opposition?
In fact, it is likely that the market rate of interest is rising — for whatever reason — and the Fed has to respond in ways that keep a lid on credit creation so as to avoid bubbles. That is, in response to rising market rates, the Fed must raise rates on reserves lest its member banks flood the economy with new loans — and with money.
This is now a possibility because it looks like there is now an increased demand for loans. After the long years of the Great Recession, private companies are finally beginning to expand business again and demand more loans from the banks. What has caused this change is not an easy question to answer. It might be that there is now less regime uncertainty. The financial crisis of 2008 ushered in an era of increased interventionism on all fronts, which is hardly conducive to a good investment climate. Now, the current administration is perceived – rightly or wrongly – to be more friendly to free markets. Investors therefore feel more confident in expanding business. Furthermore, the many government interventions following the financial crisis kept alive businesses and maintained malinvestments that should have been liquidated at the outset of the Great Recession. So, instead of a short, sharp depression it took several years before capital goods were rearranged and markets adjusted to more realistic expectations of consumer demand. One of the main causes of uncertainty was the Fed’s many interventions in the economy, and it’s decision to normalize policy in 2014 — in spite of the fact this policy is only be carried out at extremely slow speed — is one of the main reasons the market is waking up again.
But whatever the causes may be, there is now more optimism in the market and an increased demand for loans. And since the money supply is so far not expanding at a particularly fast rate (see here for the Rothbard-Salerno money supply measure), and there is no increase in the savings rate to offset the increased demand for loans, private businesses are bidding up the price of credit.
Money-supply growth is relatively low:
U.S. personal saving rate 2008-2019:
The Fed Follows Along
In this environment, the Fed simply has to follow the developments in the market and raise its own rates unless it wants to start a new credit expansion.
Hayek described this mechanism in 1929 (p. 167ff): with a greater demand for loans on the part of business, the banks, operating on the fractional reserve principle, would have a choice: raise the interest rate to equilibrate the investment demand with the supply of savings, or issue new fiduciary media at the old rates — or at any rate, at interest rates lower than they would have been had they only been set by the demand for and supply of savings. So far, the banks have refrained from issuing fiduciary media, in large part because it is still a good deal to keep reserves at the Fed (and they are in any case not yet in a position to create new fiduciary media – see below).
The following chart illustrates the point: for the longest time both the market interest rate, illustrated by the 3-month LIBOR, and policy rates were virtually flat. Then in late 2015, LIBOR started rising ahead of the federal funds rate.
Market rate of interest versus policy rates:
There is a complicating factor: the amount of excess reserves has been steadily declining for two years now. Does this not mean that the Fed has failed in its attempt to neutralize the effects of its unconventional policies and that we’re in the midst of a huge credit expansion? After all, the amount of bank reserves with the federal reserve system has fallen from a high of nearly $2.7 trillion in August 2014 to about $1.5 trillion in May 2019. However, all demand deposits are still fully backed by reserves, if only barely so, and the reduction in excess reserves has therefore not caused a credit expansion. Rather, it should be seen in the same way as a private individual who has hitherto kept a large proportion of his wealth in the form of cash but then decides to invest it. Such behavior is precisely what we should expect when the economic environment is improving and business is picking up: During financial crises and depressions, people and businesses will pile up money balances because they are increasingly uncertain about the future. And when conditions improve again, and people begin to feel more certain, they will draw down their accumulated cash balances, and either consume more or invest their funds in the economy. . (For more on this, see Hoppe’s article "The Yield from Money Held.")
The banks function in precisely the same way, with excess reserves being the analogue of increased cash balances. So long as the banks operate at or above 100% coverage of demand deposits, their lending out excess reserves can no more be seen as credit expansion than can the decision of an individual to invest his accumulated cash balance.
Reserve balances (blue) and demand deposits (red):
Prospects for the Future
This does not mean that all is well. For example, a lot of businesses (e.g., Netflix) have been financed and refinanced when the interest rate was extremely low. Will they be able to transition to an environment where debt isn’t that cheap? And just how many zombie companies have been kept alive by artificially low interest rates?
More importantly, the market rate of interest has reversed its upward trend and is now falling again, which indicates that the budding boom of the last few years is already over. While the Fed appears to be oblivious to the possibility of an economic downturn, others are not so sanguine. The American trucking industry is in dire straits as demand for trucking has evaporated, suggesting in turn that there is significantly less business activity now than one year ago. Significantly, the Fed may inadvertently strengthen the downward trend, as the spread between the market rate of interest and the Fed’s policy rates has narrowed, while the Fed has chosen to maintain current rates . This means that it is now a better investment for banks to increase their balances at federal reserve banks than to loan out money, and the data seem to indicate that they have done so, as reserve balances have increased by about $125 billion from May 1 to June 12.
Far from being upset with his central bank, then, President Trump should recognize that the Fed's lack of dovishness has allowed more market freedom in setting the interest rate in a long time. This does not mean that God’s in his heaven and all’s right with the world. If the market interest rate continues to fall without any action by the Fed, we can expect liquidity to drain fast from the market, as the Fed rewards the banks for just sitting on their cash.
To pursue a more sustainable policy, the practice of paying interest on excess reserves must be ended. To do this without causing credit expansion, it is necessary to neutralize the reserves. This can perhaps be done by open market operations, as possible Fed nominee Judy Shelton has suggested, but a different approach is preferable: now is an excellent time to enforce a 100% reserve requirement on the banks and thereby prevent future credit expansion. While this may cause some disruption to the banking sector, the negative impact can be lessened by, for instance, at the same time liberalizing the financial sector, thereby significantly reducing compliance costs and increasing the possibilities for productive investment, or by shelving all talk of trade wars and tariff increases. Once that is done, there will be no reason to keep the Federal Reserve around and it will be a comparatively easy task to eliminate the central bank and finally remove the state entirely from the business of producing money.