Just How Will Interest Rates Be Raised?

September 14, 2015 at 9:17 am Leave a comment

While guessing when the FED will begin raising short-term interest rates is a fun parlor game, a more technical but almost as important question is just how the FED will accomplish this goal. This question was raised in a recent article in the New York Times.

Raising interest rates is not as easy or mechanical as it once was. It seems to me that credit unions would be well advised to understand precisely how the FED plans to raise interest rates under these somewhat unprecedented circumstances.

Why are these conditions unprecedented? Because, since 2008, Congress has given the Federal Reserve the authority to pay interest to financial institutions holding excess reserves in Federal Reserve Banks. Regardless of whether or not you think this was a good move, the result has been that the Federal Reserve is now sitting on more than a $1 trillion in bank reserves. This huge amount of reserve held by the FED greatly complicates the mechanisms it will have to use when it finally decides it is time to raise interest rates.

For instance, the FED used to be able to have a decisive impact on short-term interest rates by simply raising the interest rate it charged for financial institutions wishing to borrow funds overnight. It would do this primarily by  selling treasury securities that were purchased by banks.  This decreased the amount of excess money financial institution  had to lend to each other and nudged the interest rate they  charged to lend to one another upward.   Today it would be virtually impossible for the FED to jettison the huge amount of securities it would have to sell  in order to put upward pressure on interest rates. In addition, non-bank financial intermediaries, that don’t have direct access to interbank loans,  are beginning to have a large impact on lending.

So how exactly does the FED plan to raise interest rates? Most importantly, in addition to its more conventional techniques,  it is going to effectively borrow money from banks and non-banks at interest rates higher than they could get making traditional bank-to-bank  loans. As Simon Potter, the Federal Reserve Bank of New York official in charge of executing this policy explained in a speech in 2014, the FED assumes that these higher interest borrowings will effectively set the floor at which other loans will be made by and to financial institutions. The thinking is that the  financial intermediaries  will not be willing to lend money at rates lower than they can get from the FED.

We will have to wait and see if he is right and hope  that the FED’s unchartered financial manipulation doesn’t have intended negative consequences for smaller lenders. In the meantime, I provided you with some background information that you can further delve into if you choose.

Entry filed under: Economy, General. Tags: , .

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Authored By:

Henry Meier, Esq., General Counsel, New York Credit Union Association.

The views Henry expresses are Henry’s alone and do not necessarily reflect the views of the Association.

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