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The Fed: December Liftoff Now Likely

The Fed didn’t take action in September, leaving short-term interest rates near zero since December 2008. This was consistent with the majority of market participants’ expectations.

Fed officials have continued lowering their projections of the pace of raising interest rates in the past four projections. See the chart below:

The projection on GDP in 2015 was revised upward, and the unemployment rate projection went down, indicating the Fed improved its outlook for economic conditions. But PCE (personal consumption expenditures) inflation was projected largely lower than the previous projection.

Here’s what to expect next – and don’t panic when it happens.

December now has become the mostly likely case for the initial rate increase by ¼ percent or ½ percent. Either ¼ percent or ½ percent increase is a fairly small increase in the federal funds rate compared to its historical average level of 5 percent. The move is rather a signal to the market that a tightening monetary policy environment is coming.

It is more interesting to see if the Fed will pull it back in the near future as other central banks did after the initial rate increase takes place, or at what pace the Fed will continue to raise the interest rates.

A higher interest rate normally puts constraints on borrowing. But the first interest rate rise could be seen as a signal of even higher rates in the future. Hence, consumers and businesses may borrow sooner than later, boosting borrowing in the short term.

As lenders, due to higher interest rates, banks have a higher opportunity cost for having their excess reserves sit in the central bank. In other words, banks have more incentives to lend.

The stock market will immediately react to the Fed’s action on raising rates. But the dust may not take long to settle on the table. History shows stock market performance has little correlation with the broader economy using a longer perspective.

3 Comments Post a comment
  1. Katy Delay #

    I’d like to hear more about the Fed’s new tactic of reverse repos (at least that’s what I recall the name to be), in an effort to prevent the interest rates from falling below zero. From what I understand, current markets pressures would have already sent US rates below zero, but the Fed has been doing something to counteract this, even though in Europe negatives rates are already functioning. What are they up to? And why don’t we hear more about this?

    Like

    September 18, 2015
    • As long as the central bank pays interest on bank reserves (including required and excess), the absence of reverse repos alone would not push interest rates down to the negative territory (maybe temporarily). The 25 basis point interest rate on excess reserves is the opportunity cost for banks to lend and these banks are not current participants in the reverse repo market. The participants are financial institutions who are illegible for receiving interest on bank reserves. If we call off reserve repo operations, those financial institutions may offer lower interest rates, but they are only minority of lenders with limited influence.
      There was hot debate about if the Fed should use reverse repos as a main tool to raise interest rate until it claimed that the primary tool would still be its federal funds rate and reverse repo rate would be only used as complementary tool and it would gradually die off.

      Like

      September 18, 2015
  2. I wrote about the reverse repo facility as follows (it shows up in the liabilities portion of Table 1 of the Fed’s balance sheet, the Board of Governors H.4.1 release (weekly on Thursday afternoons):

    Conditions in the money market are such that, in the absence of the 0.05 pct. rate floor provided by Fed’s reverse repo operation, the “floor” rate would fall below zero, at least temporarily. And as long as the Fed is rolling over maturing securities in the FOMC portfolio, it’s going to be difficult for it to hit its rate target ceiling (now 0.25 pct., theoretically if the Fed ever moves, 0.50 pct.). So this is why I advocate (a) killing the reverse repo facility and letting rates (probably temporarily) fall below zero and (b) letting maturing securities roll off (be redeemed and thereby reduce the Fed’s FOMC portfolio passively, without selling securities). The Fed also (c) could sell long-term securities that it holds during the (a) period (they would command a premium in the market then). Overall you have to find a way to shrink the Fed’s balance sheet ($4.5 trillion now), of which about $4.0 trillion consists of the FOMC’s portfolio. Also, the Fed’s shrinkage (combination of b and c) probably would induce short-term rates to start rising eventually. The Fed then could let rates rise toward target (and raise the target) without the reverse repo facility (a). — Walker Todd, Chagrin Falls, Ohio

    Like

    September 18, 2015

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