On December 16th, the Federal Reserve raised interest rates for the first time since 2006. This change in monetary policy has an effect on everyone to some extent. The interest rates you pay and earn, your ability to access credit, and even your prospects in the job market are affected by the decisions of the Fed. By adjusting the “federal funds target rate,” the Fed can significantly influence the fiscal behavior of both businesses and individuals.
While rates have only moved from 0 to 0.25%, a closer look shows that we have been feeling the effects of monetary tightening for almost two years. As a result, the Fed will need to tread carefully as they consider the consequences of raising rates in 2016. This has become evident as the recent swoon in the global capital markets has in part been blamed on the Fed’s December decision to begin raising rates.
The members of the Federal Open Market Committee (FOMC), currently led by Janet Yellen, meet in Washington eight times per year to discuss the economic conditions of the twelve economic districts of the country. Their mandate is to set monetary policy that will effectively keep inflation at a low, positive trajectory and the labor market strong. To do this they pour over various economic data points and set a monetary policy primarily by raising or lowering their target for short-term interest rates (Federal Funds Rate). This rate is defined as: “The interest rate at which depository institutions lend balances to each other overnight.”1
To influence interest rates and achieve this target, they utilize three key monetary tools: buying and selling bonds, setting the discount rate, and setting the reserve requirements for U.S. banks.
The Fed uses its own balance sheet to buy and sell government bonds to control the interest rates on these securities. Through a process called “open market operations,” the Fed buys bonds, effectively creating the demand that lowers the interest rates on these securities. In exchange for the bonds, Federal Reserve Notes (aka dollars) are created and distributed to the seller. This seller then deposits the notes in the bank which effectively raises the bank’s reserves.
Conversely, the Fed can create supply by selling bonds which cheapens their prices and raises the interest rates on the securities. In this case, the Fed will receive dollars for selling the bonds and cancel the Federal Reserve Note that it had created. This process was created to ensure that banks have sufficient funds to meet the regulated reserve levels required by the Fed to meet unexpected outflows.
As a complement to open market operations, the Fed also sets the discount rate at which a depository institution can borrow directly from its district Federal Reserve Bank. Unlike the federal funds market, the loans arranged at the discount window must be collateralized and are generally done to relieve liquidity strains for depository institutions that cannot borrow directly from another institution.
While these tools have been successful at manipulating the Fed Target Rate for years, everything changed in 2008 when the target rate hit zero. Once this occurred, the Fed was forced to look to new methods of monetary stimulus to stabilize the economy. These unconventional programs (labeled QE1, QE2 and QE3) were not only intended to keep the target rate low, but also attempted to keep longer term rates low. To achieve this, they began buying Treasury bonds of all maturities.
The purpose was twofold. First it was needed to shore up the reserves of the fledging banking system while it was also intended to increase the monetary supply in the system. As banking reserves were replenished, the intention of the Fed was for the banks to lend more freely, ultimately boosting the levels of investment and spending in the economy which would lead to more job creation.
Looking back seven years later, this unconventional use of the balance sheet appears to have had mixed results. While the economy eventually recovered and the S&P 500 moved from $676 to $1,880, the Federal Reserve was left with a massive balance sheet without a plan to decrease it. As of January 13th, 2016, the Fed had amassed a $4,501,695,000,000 (4.5 trillion) balance sheet made up primarily of U.S. Treasury Bonds and Mortgage Backed Securities.
The Fed now finds itself in a precarious position as its debt burden has risen to an unprecedented level. At this point, the market believes that a balance sheet reduction of any type will decrease money supply, push interest rates higher and subsequently increase the probability of a recession.
In simple terms, the QE programs focused on buying bonds of all maturities, hence unwinding these positions will increase the supply of bonds. This combination of $215 billion worth of bonds maturing from the balance sheet in 2016 and the Chinese selling bonds at a pace of nearly $300 billion per year will continue to put pressure on prices. To keep rates in check, we fully expect the Fed to continue to provide demand by reinvesting proceeds for the foreseeable future. After all, a potential supply-demand imbalance will cause prices to fall and interest rates to rise (tightening effects).
Lurking in the Shadow
From December of 2008 to December of 2015, the Fed kept the target rate at zero. While on the surface, this may have appeared like there was little done to change monetary policy, the actions of the QE programs continued to have the same “monetary easing” impact as lowering the target rate well below zero. Academics Jing Cynthia Wu (University of Chicago) and Fan Dora Xia (University of California) studied the microeconomic effects of the unconventional monetary policy and developed a factor based model2 to estimate the effects of the policy in the form of a Shadow Fed Funds Rate. The study results, titled “the Wu-Xia Shadow Rate”, showed that the large scale asset purchases and forward guidance (i.e. both the minutes of Fed meetings and interim remarks given by FOMC members when they make speeches), replicated a 300 basis point (3%) easing of the Fed Funds Rate between March of 2009 and March of 2014. The model pictured above plots the shadow rate which reached -3%.
These unconventional policies were intended to further lower the interest rates individuals and corporations paid to borrow money and to add money supply to the banking system, all in hopes of stimulating the economy. In Wu & Xia’s estimation, QE1 (October of 2008 to March of 2010) moved the shadow rate from 0.97% to -0.48%. QE2 was less effective as it was smaller and well anticipated by the market hence only moving the rate from -1% to -1.12% while the massive scale of asset purchases in QE3 had a pronounced effect, easing the rate from -1.26% to -2.80% between August of 2012 and October of 2014. The model also factored in the Fed’s communication to the market which moved the rate slightly lower between each QE program. Bottom line was — the effective rate ended the program at minus 3%.
In October of 2014, the Fed announced that they would be ending the asset buying program and the shadow model began to show an immediate tightening effect. As the free money disappeared in the 13 months that followed, the shadow rate showed a rise of 280 basis points (2.8%). During this period of “stealth tightening”, the market reacted in a similar manner to periods of past tightening cycles: increased volatility, a strengthening dollar, a weakening commodities market, and increased pressure on both stocks and corporate bonds. All of which are normal when the Fed is in the middle of a tightening cycle.
As in most cycles of the past, the old adage rings true: “When the Fed begins to put on the brakes, somebody goes through the windshield.”3
Effects on You and the Markets
As noted above, the recent volatility in the market is not uncommon when rates are rising. The past six months have shown that the reaction to the guidance of the Fed can be harsher than the actual movement in monetary policy. Between October of 2014 and December of 2015, the Fed left all policies unchanged yet the reaction to that decision and the guidance produced a “stealth tightening”. Once the Fed finally decided it was time to raise rates, the market quickly reacted in a manner that disagreed with the policy move and capital markets drastically sold off. The current reaction has reinforced the market’s belief that any future movement in rates will be dangerous and will push the economy toward a recession. We feel these fears are overinflated as the consumer-led U.S. economy still appears to be on solid footing. In addition, while we recognize that the Chinese economy is slowing, we do not believe this will lead to a global recession. We feel that the recent deterioration in oil prices and capital market assets will cause the Fed to reexamine their views toward inflation and force them to acknowledge these tighter conditions, ultimately affording them more patience prior to further rate hikes.
While it may be true that tightening increases the cost of borrowing and incentivizes savings, eventual small increases in the target rate should not smother the economy as long as they are executed once the markets digest the effects of everything that has occurred to date. It is important to point out that consumers make up close to 70% of U.S. GDP and their balance sheets are strong. The total U.S. household debt as a percentage of disposable income has fallen from a peak of 133% in December of 2007 to 104% as of September 2015. These healthier balance sheets combined with falling unemployment and cheaper gasoline should boost consumer spending and lift GDP regardless of the effect from the recent rate hike.
While the stealth tightening may have had a typical effect on the global markets, the visible effects on personal finances will soon start to hit the consumer. The rates lenders charge on credit card and auto loans and mortgages typically rise one to two billing cycles after a Fed move. Fortunately for consumers, these rates will still be historically low. Unfortunately, the rate banks pay on savings accounts and CD’s will likely not change quickly because the banks are over collateralized and their balance sheets are also strong hence they do not need the deposits to shore up reserves.
As stated, the recent reaction of the global markets should force the Fed to re-examine its guidance to help stem the surge in volatility. While rate increases are the Fed’s way of saying that the economy is on firm ground, not hiking may be interpreted as a sign that the Fed is less confident. A change in guidance could allow the Fed to walk that middle ground and buy time for the markets to stabilize. After all, we have had a stealth tightening of 300 basis points in the past year and the Fed has only acknowledged the last 25.
If the Fed were to give a better explanation of the tightening effects relating to the end of quantitative easing (QE3), this may help calm the current fears of a policy misstep. They should publicly recognize that the traits of a normal tightening cycle are now in place (i.e. stronger dollar, weaker commodity and equity prices and increased corporate bond spreads). Without addressing these conditions, any further actual rate increases will be labeled a “misstep”.
1 Source: Federal Reserve Bank of New York
2 Source: “Measuring the Macroeconomic Impact of Monetary”, Wu and Xia – Working Paper No. 13-77 (2013)
3 Credit: Stan Jones, New York Times, May 2000
Credit: “Operating in a “Shadow Rate” World – Fed Funds Closer to Negative 3%”, Matthew Kerkhoff – Financial Sense: July, 2014
Credit: All statistical data from Bloomberg LP., Federal Reserve Bank of Atlanta, and the Federal Reserve Bank of St. Louis
Mr. Heckscher is Senior Vice President and Director of Fixed Income at Pennsylvania Trust.
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