The Fed Awakens

A long time ago, in an economy far far away, was the last time the fed hiked rates.

[Reprinted from the January 2016 issue of the LMR.]

This month the Fed hiked its target for the federal funds rate, which is the interest rate that banks charge for overnight loans of reserves. This was the first time the Fed had raised rates since June 2006, and is the first time rates have been higher than zero since December 2008. (Strictly speaking the target for the last seven years was a range from 0 to 25 basis points, whereas now the target range is 25 to 50 basis points, meaning 0.25 percent to 0.50

Americans have become accustomed to the situation and so the shock may have worn off. But imagine if the government had somehow held the price of, say, electricity at virtually $0 per kilowatt-hour for seven years, or the price of lumber. It is obvious that this “cheap” policy for inputs wouldn’t help the economy, but would serve only to channel scarce resources into the wrong businesses. After all, as the Austrian economists taught us, market prices serve a definite social function. It hampers the ability of prices to communicate information between consumers and producers when the government interferes. When the central bank fosters credit expansion and artificially low interest rates, this only gives the illusion of prosperity.

However, beyond the usual story of the Fed distorting the structure of production, in our current cycle we face something new. Typically, the Fed will “hike rates” by selling off assets and thereby draining reserves from the banking system. (In some cases the operation is merely relative to the pre-existing trend: In other words the Fed might slow the rate of injection of new reserves, leading to a higher fed funds rate.) Yet this time around, the Fed doesn’t want to unload its balance sheet, for fear of crashing certain asset prices. So the way it will “raise rates,” at least for now, is to increase the interest rate paid on excess reserves.

As of December 17, the Fed is now paying 50 basis points to commercial banks for both their required and their excess reserves. Thus, rather than sucking money out of the system and causing the price of renting it to rise, instead the Fed is bribing bankers to keep their money parked at the Fed, thereby causing its price to rise. (For an analogy, if the government wanted to increase the price of wheat, it could (a) destroy some of the existing crop or (b) buy some of the existing crop and put it in storage).

We will keep LMR readers posted but just keep in mind that this is not your grandfather’s rate hike.