Why Interest Rates Have Been Low for So Long (GS, JPM)
By Sean Ross | June 8, 2016 — 4:00 PM EDT
Interest rates in the United States are extremely low by historical standards. They have remained low for years, fixed by frustrated central bankers dedicated to performing monetary experiments on the economy. The Fed normally offers academic and theoretical explanations for super-low interest rates, but practical reality and political interests also play their parts.
Very Low for a Very Long Time
As of May 19, 2016, the effective federal funds rate was at 0.37%, almost exactly midway inside the Federal Reserve’s target range of 0.25 to 0.5%. A 0.37% nominal rate is low, yet this is the highest realized rate since late 2008. That is when the Fed established a target range and moved away from a specifically set fed funds rate. The Fed used to peg overnight loans at 1, 5 or 15%. Starting in December 2008, the Fed moved from a 1% set rate to a target rate between zero and 0.25%.
The Fed had never set interest rates at 0% before, as it worried that this might panic money markets. Money market fees would almost certainly exceed paid interest with a 0% fed funds rate, scaring away participants in a very large market. The new target range increased flexibility to coordinate with money market dynamics.
The Fed’s Zero Interest Rate Policy and Excess Reserves
Ben Bernanke, then chairman of the Fed, justified the zero interest rate policy (ZIRP) in 2008 as a mechanism for boosting spending, borrowing and investment. This is classic Keynesian monetary theory: discourage savers by lowering rates, forcing them to spend, encourage spenders to spend even more through cheap borrowing costs and drive investments from safer assets, such as Treasurys and certificates of deposit (CDs), into riskier equities or junk bonds.
The ZIRP era of 0 to 0.25% lasted seven years, between December 2008 and December 2015, until the Federal Open Market Committee (FOMC) finally increased its target fed funds rate. The Fed emphasized, « The stance of monetary policy remains accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2% inflation. »
Seven years of ZIRP also coincided with a brand new policy; the Federal Reserve began paying interest to big banks if they parked excess reserves at the Fed bank. In 2015, 93% of Fed bank reserves were excess. The Fed paid more than $100 million to Goldman Sachs Group Inc.. (NYSE: GS) in 2015, while JPMorgan Chase & Co. (NYSE: JPM) received more than $900 million. When the Fed hiked the rate range from 0.25 to 0.5%, it also doubled the rate paid on excess reserves.
Keynesian theory says more spending and more debt are stimulative, thanks to the circular flow model of the economy. If this is the reasoning behind ZIRP, why pay interest to banks on excess reserves? After all, the Fed made it more profitable for banks not to make overnight loans to each other. It was also far safer to not make loans to the public or invest in a speculative market.
The Fed offered two explanations for interest payments on excess reserves. The first explanation was that it worried that too much bank lending would make the money supply hyperactive, triggering very high inflation; and second, that it wanted a firmer, non-zero floor on short-term interest rates. Ostensibly, this could have been better accomplished by raising the target rate from 0.25 to 0.5% in 2008, rather than from 0% to 0.25%.
Practical and Political Reality
There are more practical and less romantic explanations for low rates and excess reserve payments, but they call into question the Fed’s oft-touted independence. The first explanation surrounds the U.S. government’s enormous debt. By the fourth quarter of 2015, nearly two-thirds of the national debt was serviced by government bonds with a duration under one year. Ultra-low interest rates help the Treasury afford its bills. ZIRP also inflates the stock market, something sitting politicians and wealthy investors desire.
Second, the Federal Reserve has a very cozy relationship with major banks. Private banks choose six of the nine directors for the Federal Reserve banks. A rotating employment door exists between many Fed branches and major financial institutions. In 2011, Congress forced a partial audit of the Fed and found $16 trillion in previously unknown allocations to corporations and foreign banks. The Fed has heavily resisted calls for further audits.
Results Have Been Poor
Results from easy money, debt and spending policies have been underwhelming, regardless of the reasons. Empirically, the policies employed by the Federal Reserve were unsuccessful by their own standards and stated goals, though proponents offer a counterfactual defense along the lines of « things might have been even worse » without these efforts.
After nearly a decade of ultra-low interest rates, buoyed by enormous government deficit spending, the U.S. economy found itself with the slowest recovery in its history. Policymakers have been very hesitant to change, however, and very few expect a different course anytime soon. The net effects for average Americans have been disappointing, but theoretical, practical and political pressures for low rates are still in place.
Janet Yellen and the Fed Raise Interest Rates for First Time in 2016
By Chris Matthews, Dec. 4th, 2016
The Federal Reserve’s interest-rate setting committee on Wednesday said that it would raise interest rates by a quarter of a percentage point to between 0.50% and 0.75%. It is only the second time the U.S. central bank has raised interest rates since 2006, when the economy was yet to be hit by the financial crisis.
The move was widely expected, as a falling unemployment rate and rising wages signaled to the Federal Open Market Committee (FOMC) members—the Fed’s interest rate policy-making body—and the market that overall price increases would soon meet and potentially surpass the central bank’s goal of 2% per year. Markets in particular have begun to change their minds on the topic of inflation. The election of Donald Trump has convinced many that deregulation of business and higher government deficits will lead to faster growth and rising prices.
As the chart above shows, differences between the yields on U.S. government bonds and inflation-protected bonds indicate that investors believe higher inflation will soon be on the way. That said, inflation expectations remain well below historical norms, and even below levels seen a few years ago when the economy was weaker. This reinforces the Fed’s slow approach to further increases. « The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate, » the Fed’s statement reads. « The federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. »
The decision to raise rates was unanimous, indicating that Janet Yellen has been successful in satisfying both FOMC members who want rates to go up faster to blunt inflation and those who believe interest rates should be kept low to nurse the convalescent economy.
Though the Fed appears to still want to take things slow, there were signs it could move faster if the economy continues to improve. Data released along with the Fed announcement showed that the majority members of the FOMC now forecast three rate hikes in 2016, up from two in September. Shortly after the meeting, bond yields rose on the prospect of faster rising interest rates in 2017.
On the other hand, stock markets fell shortly after the decision, underscoring the general uncertainty among market participants as to whether the Fed is striking the right balance between heading off inflation and providing adequate stimulus for the economy.
Fed Might Raise Rates Relatively Soon
By Joana Taborda, Feb. 2nd, 2017
The US economy is expected to continue to expand at a moderate pace and wait too long to raise rates would be unwise, Fed Chair Yellen said in prepared remarks to the Congress. However, the economic outlook and fiscal policy face uncertainty and monetary policy is not on a preset course thus any changes will depend on incoming data, Fed Chair added.
Excerpts from Fed Chair Yellen Testimony Before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, Washington, D.C. February 14, 2017:
My colleagues on the FOMC and I expect the economy to continue to expand at a moderate pace, with the job market strengthening somewhat further and inflation gradually rising to 2 percent. This judgment reflects our view that U.S. monetary policy remains accommodative, and that the pace of global economic activity should pick up over time, supported by accommodative monetary policies abroad.
As always, considerable uncertainty attends the economic outlook. Among the sources of uncertainty are possible changes in U.S. fiscal and other policies, the future path of productivity growth, and developments abroad.
At its December meeting, the Committee raised the target range for the federal funds rate by 1/4 percentage point, to 1/2 to 3/4 percent. In doing so, the Committee recognized the considerable progress the economy had made toward the FOMC’s dual objectives. The Committee judged that even after this increase in the federal funds rate target, monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2 percent inflation.
At its meeting that concluded early this month, the Committee left the target range for the federal funds rate unchanged but reiterated that it expects the evolution of the economy to warrant further gradual increases in the federal funds rate to achieve and maintain its employment and inflation objectives. As I noted on previous occasions, waiting too long to remove accommodation would be unwise, potentially requiring the FOMC to eventually raise rates rapidly, which could risk disrupting financial markets and pushing the economy into recession. Incoming data suggest that labor market conditions continue to strengthen and inflation is moving up to 2 percent, consistent with the Committee’s expectations. At our upcoming meetings, the Committee will evaluate whether employment and inflation are continuing to evolve in line with these expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.
That said, the economic outlook is uncertain, and monetary policy is not on a preset course. FOMC participants will adjust their assessments of the appropriate path for the federal funds rate in response to changes to the economic outlook and associated risks as informed by incoming data. Also, changes in fiscal policy or other economic policies could potentially affect the economic outlook. Of course, it is too early to know what policy changes will be put in place or how their economic effects will unfold. While it is not my intention to opine on specific tax or spending proposals, I would point to the importance of improving the pace of longer-run economic growth and raising American living standards with policies aimed at improving productivity. I would also hope that fiscal policy changes will be consistent with putting U.S. fiscal accounts on a sustainable trajectory. In any event, it is important to remember that fiscal policy is only one of the many factors that can influence the economic outlook and the appropriate course of monetary policy. Overall, the FOMC’s monetary policy decisions will be directed to the attainment of its congressionally mandated objectives of maximum employment and price stability.