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Fears of Soaring Rates are Overblown (Part 1 of 2)

The Federal Reserve Bank has increased its balance sheet by an astonishing $1.6 trillion since the financial crisis began in 2008. This action added much needed liquidity to financial markets and lowered interest rates for everyone. Some people fear an unwinding of these assets will lead to soaring interest rates. I don’t agree.

Part 1 of this two-part article provides a short background on monetary policy and explains how the Fed has been using their powers to influence interest rates since the onset of the financial crisis. Part 2 examines how a reversal in Federal Reserve policy may affect U.S. interest rates and the economy.

The term "monetary policy" refers to the actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money. These actions help promote national economic goals of stable prices and maximum employment.

The Federal Reserve System (the Fed) uses three tools to implement monetary policy; open market operations, the discount rate, and reserve requirements. The Board of Governors of the Federal Reserve System is responsible for the discount rate and reserve requirements, while the Federal Open Market Committee (FOMC) in responsible for open market operations.

Using the three tools, the Federal Reserve influences the demand for, and supply of, cash balances that depository institutions (primarily member banks) hold at Federal Reserve Banks. In this way, the FOMC alters the federal funds rate. The federal funds rate is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. In turn, these actions control the interest rate that one bank charges another for overnight lending, and thus indirectly influences all lending rates.

A change in the FOMC policy can trigger a chain of events that can affect all interest rates, including Treasuries, mortgages, corporate bonds and credit cards. These changes ultimately have an effect on a range of economic variables, including employment, output and prices of goods and services.

During an economic downturn, the Fed lowers short-term interest rates by purchasing Treasuries and other securities from member banks. This pushes cash onto the balance sheets of those banks, and in turn, the banks lend at lower interest rates. Just like any other market, more supply means lower prices. In this case, more cash in the banking system means a lower cost to borrow money.

The bonds that the Fed buys become an asset on the Federal Reserve’s balance sheet. It’s normal to see the balance sheet grow during a recession, as the Fed buys more securities to lower rates, and shrink during robust economic activity to raise rates.

The past few years have resulted in unprecedented FOMC asset buying. Not only has the committee taken the unusual action of buying assets other than U.S. Treasuries, the Fed bought mortgage-backed securities and government agency debt on the secondary markets.

Total balance sheet assets increased dramatically from $869 billion in August 2007, to a peak of $2.725 trillion in July 2011. The latest data on December 7 shows a balance of $2.803 trillion.

Figure 1 illustrates the increase in the Fed’s balance sheet since August 2008. This graph depicts the amount of money that depository institutions (banks) maintain in their accounts at their regional Federal Reserve Banks.

Figure 1: The Federal Reserve’s Monetary Base

The security portfolio of the Fed’s balance sheet is highlighted in Figure 2. Excluding direct loans to banks, much of the Fed’s activity involved the purchase of Treasury bonds, agency bonds and mortgage-backed securities from January 2009 through June 2011.

Figure 2: Securities Held by Federal Reserve Bank

The Fed took four major actions since 2008 that increased their monetary base. The first action was taken as a crisis management measure to keep the banks solvent during the onset of the crisis, the second action was taken in early 2009 to stimulate the economy and keep the mortgage market fluid, and the last two actions added more stimulus by further lowering intermediate- and long-term interest rates.

1)      October 2008 – December 2008: The Fed Funds Rate is lowered three times from 2.0% to 0.0%-0.25%. In addition, the Fed loans Treasury securities directly to banks to help them stay solvent. The Fed takes on so-called “toxic assets” as collateral because the secondary market for these assets stopped functioning.

2)      January 2009 – March 2010: Fannie Mae and Freddie Mac are taken over by the government in late 2008 and that causes the mortgage market to freeze. The Fed buys $1.25 trillion in mortgage-backed securities to get the market moving and to nudge mortgage rates lower.

3)      November 2010 – June 2011: The Fed directly buys $600 billion in Treasury securities in a direct effort to push intermediate- and long-term rates lower.

4)      October 2011 – TBD: Operation Twist (QE3).  The Fed extends maturities on Treasury holdings to hold down intermediate- and long-term interest rates.

Figure 3 highlights changes in interest rates during 2008-2011. The shaded areas labeled 1, 2, 3 and 4 correspond to the periods of major action by the Fed.

Figure 3: Interests Rates and Fed Action

During Action 1, T-bill yields went to near 0 percent by year-end 2008 after the Fed took the targeted rate for bank overnight lending all the way down to 0.00 to 0.25 percent. The 10-year Treasury yield fell initially, but bounced back by the summer of 2009.

Action 2 was an important step since the housing market was suffering terribly from price declines, mortgage delinquencies, defaults, and foreclosures, and the market for secondary mortgages froze. The buying of over $1 trillion in secondary mortgages added liquidity to the mortgage market, and it also helped push interest rates lower. This action was referred to a quantitative easing (QE).

Action 3 was a direct buy of $600 billion in intermediate-term Treasury securities in an effort to push overall rates lower. This action was commonly referred to as QE2. It was successful. The 10-year Treasury fell from near 4 percent to below 2 percent, and a conventional 30-year mortgage fell below 4 percent for the first time in 50 years.

Action 4 is commonly referred to as Operation Twist. The Fed is selling T-bills and short-term Treasury securities and buying intermediate- and long-term Treasuries. The purpose of this action is to keep intermediate- and long-term rates low.

Part 2 of this article, to be published later this week, will explore how a reversal in current Federal Reserve policy may affect U.S. interest rates and the economy.