The Power of the Federal Reserve and Interest Rates

Happy 4th of July! I'm taking the day off to enjoy a cookout with the family. I hope you all have a great holiday. I do have an article to share that was written a couple of weeks ago. It's from Prof. Jeff Wiltzius who is an economics professor and a long-time friend of mine. In my conversations with him over the last few years, I've been impressed by his knowledge in economics and his ability to explain issues in a down-to-earth fashion. Prof. Wiltzius has graciously offered to write a few articles for DepositAccounts.com to share his insights into the economy and the Fed. Below is the first of these economics-related articles.

The Power of the Federal Reserve and Interest Rates

Ben Bernanke’s speech on June 19th illustrated once again the influence of the Federal Reserve on markets and interest rates. His statement that the FED was likely to slow the $85 billion-a-month bond buying program if the economy continues to show strength through the end of the year caused investor nervousness and a three day stock market plummet. According to Freddie Mac, one of America’s largest secondary mortgage buyers, interest rates have also risen from 3.35% in May to almost 4%. How can one vague statement from the Chairman of the Federal Reserve Board cause so much havoc in the financial markets?

In this economist’s opinion it is because more and more economists are becoming skeptical about whether or not the FED knows what it is doing. Even insiders like James Bullard, the St. Louis Federal Reserve Bank President, has publicly criticized Dr. Bernanke’s recent announcement stating the FED should wait for more “tangible signs” of inflation. There could be no more tangible signs of inflation than the FED’s own balance sheet.

If there is one thing that virtually all economists agree on is that if the FED puts too much money in the economy, it will create inflation, or even worse hyperinflation. Keep in mind that this balance sheet only reflects the result of the first round of quantitative easing. QE2 added $600 billion by the end of the second quarter of 2011. In September of 2012 the FED announced QE3, a policy of purchasing $40 billion worth of bonds monthly, which was subsequently raised by the Federal Reserve Open Market Committee to $85 billion a month in December of 2012. Bernanke’s latest remarks are not an end to quantitative easing. The FED is only potentially scaling back the amount of money being put into the economy each month from $85 billion to $65 billion, perhaps during the September Open Market Committee meeting.

Many economists question whether this QE policy even works to stimulate the economy. Those economists can point to the record levels of excess reserves the banking system is already holding. Excess reserves are bank reserves available to banks for lending. During recessions banks tighten up lending requirements and are willing to hold excess reserves to lower risks of loan defaults. The increased regulations in the mortgage industry have also caused higher lending requirements leading to fewer loans. An argument could be made that the FED pumping dollars into a banking system that is already holding excess reserves only serves to increase the excess reserves in the system. It does nothing to affect the underlying issues such as lack of demand for loans and more stringent requirements in the banking system. There is one more decision the FED has made that encourages banks to hold excess reserves, it now pays interest to the banks on reserve deposits held at the Federal Reserve Banks. This has never been the case in the past.

At an economic conference held this spring by the Stavros Center at the University of South Florida a group of economists voiced their inflation concerns. The keynote speakers at the conference were representatives of the Federal Reserve Bank of Atlanta. During the question and answer phase concerns were raised about quantitative easing and the potential inflationary impact on the economy. The FED representative responses to the group of about 35 economists were not well received. When asked about the potential inflation, the FED spokesman said their data did not currently indicate inflationary pressure. An economist from the crowd responded to the effect, “of course you don’t see anything in the current data, we all know the effect will be felt 2 to 3 years from now.

Another economist asked about whether the FED had a plan to unwind the consequences of the QE campaigns. The FED representative explained the plan was to raise the interest rates paid on bank reserves so that banks would be encouraged to keep the money on deposit rather than to loan it out so that less money goes into the economy, slowing the inflation rate. A sarcastic remark was heard from the crowd, “so the FED’s plan is to slow inflation by putting the U.S. back into a recession”. Another economist asked if this plan had ever been tried before: the short answer was no. Another economist asked: “if the plan has never been tried before, how do you know it will work?” The FED representative responded: “it has not been used before, but we know it will work.” From the laughter coming from the economists it was clear they were not convinced.

As the meeting ended it was also clear the FED representatives were glad it was over and wanted to get out of there and that some of the economists, myself included, still had some unanswered questions. The FED representatives were gracious enough to stay and answer some one-on-one questions.

My question was on the independence of the FED and paying interest to banks. One of the reasons the FED has been successful in the past is its ability to remain free of the whims of politicians and focus on the wellbeing of the economy. One of the key reasons the FED can do that is because it is one of the few, if not the only, governmental institution that actually makes a profit which goes into the U.S. Treasury. This makes it so the FED does not have to ask Congress for funding. So I asked, ‘if the FED is paying higher interest rates to banks, what happens if it goes into the red and is no longer self funded. Won’t that cause the FED to lose its independence?” If Congress holds the purse strings, it will want to make the FED justify its activities. I was very shocked at his answer. He explained that a loan could be made by the Federal Government to cover any shortfalls. My response: “oh, you mean like the post office”.

The U.S. Postal Service is a hybrid private/public corporation so officially it is not funded by taxpayers. Unofficially, however it lost over $15 billion in fiscal 2012, has a total net deficiency of over $34 billion (what in the private sector would be equivalent to an off-balance-sheet loan and would be illegal). This does not even include the $11 billion in unfunded pension plan obligations. Do the American people really need a Federal Reserve System that is as dysfunctional as the Postal Service. As an economist I have always been a supporter of the FED, its leadership, and especially its independence from political pressures and influence. With the current FED policies, my confidence is eroding.

I hope I am wrong for the sake of our country. The latest recession has been named the Great Recession and supposedly resulted in the worst economy the U.S. has had since the Great Depression. I disagree. I lived through the stagflation (inflation and unemployment at the same time) of the early 1980’s. The misery index, the combination of inflation and unemployment, was much higher (up to 50% higher) during that earlier period of time. So not only were unemployment rates high, but even people who were working watched the value of their savings and the purchasing power of their paychecks go down. Paul Volcker, the FED Chairman in that period, gave America some “tough medicine”, threw the economy into a recession, but ultimately won the inflation battle. Inflation, more specifically hyperinflation, is the one thing that can bankrupt an economy. I hope the FED does know what it is doing!