What’s The Deal With Interest Rates?

From Marketwatch, we read:

Federal Reserve Chairwoman Janet Yellen on Monday said she expects the U.S. economy will continue to improve and expects further gradual increases in interest rates will “probably” be appropriate.

“I continue to believe that it will be appropriate to gradually reduce the degree of monetary policy accommodation, provided that labor market conditions strengthen further and inflation continues to make progress toward our objective,” Yellen said in a speech to the World Affairs Council of Philadelphia.

Yellen offered no clues on the timing of Fed action in her remarks. She did not repeat the phrase that the Fed would act “in the coming months” that the included in remarks at Harvard University on May 27.

Wishy washy. Nothing new, only hints. This is par for the course.

Investors are waiting on the Federal Reserve to raise “interest rates”. But the Federal Reserve cannot unilaterally raise “interest rates”, which is poorly understood even by seasoned Wall Street professionals.

The only rate under direct Federal Reserve control is the rate of interest paid on excess reserves; this rate must be paid out of the Fed’s own profits.

Keep in mind that all profits generated by the Federal Reserve go directly to the US Treasury. The US government uses this money to fund some of its operations. Of course, it’s a drop in the bucket because the US government is hopelessly in debt; but every last bit counts, I suppose.

So each dollar that the Federal Reserve pays in interest on excess reserves to banking companies is a dollar less that it gives to the government at the end of each calendar year. Consequently, the federal deficit increases by this number. Higher rates paid on excess reserves mean less money for the federal government.

When is the last time you heard anyone mention this? I will answer that for you: never. If you read Market Watch, the Financial Times, and the Wall Street journal daily, like I usually do, then you’ve never heard them make this connection.

There’s another element to this whole witch’s brew, if I may call it that. The second interest rate which the Federal Reserve kinda-sorta can control is the Federal Funds rate – meaning, the rate at which banks lend to each other overnight. You may not realize it, but banks sometimes do this between each other to ensure that they can continue meeting minimum reserve requirements.

If the Federal Reserve is paying 0.5% on excess reserves, then no banks will lend to each other below this rate; they will simply keep the money in excess reserves instead. Banks, more than anyone, understand the value of not throwing away money. Therefore, as the rate paid on excess reserves increases, the Federal Funds rate between banks increases as well. In turn, this rate influences the individual interest rates that banks set for themselves.

The key term is “influence”. Contrary to what some people think, the Federal Reserve cannot order any bank to raise or lower interest rates. That would be socialism: economic control by bureaucrats. The banks are influenced by Federal Reserve policy, but they are not obligated to do anything regarding interest rates.

This is where the problem comes in: the Federal Funds rate is becoming irrelevant. Excess reserves are so unbelievably huge that banks no longer need to borrow money from each other to meet reserve requirements. They are sitting on mountains of digital cash in the form of excess reserves.

The implication is clear: the Federal Reserve is losing influence over general rates of interest. If they cannot influence general interest rates through the Federal Funds rate, then they have nothing left.


I sincerely doubt Janet Yellen will be raising the rate paid on excess reserves by any appreciable amount. If you’re waiting for any sort of substantial increase in general interest rates, I think you’ll be waiting a long time. Even if Janet Yellen does try to actively raise interest rates, I think the market reaction will be mostly lethargic.

The Federal Reserve has not made any major moves for nearly two years. They halted QE and monetary inflation in 2014. This was the right thing to do. If they continue to keep the monetary base stable, it will be the right thing to do. But the real test will be their reaction to the next economic recession.

Tags: , , , , ,

Comments are closed.

%d bloggers like this: