“I think we’re mysterious to people. I think they’re not sure what we do.” - Jeffrey Lacker, Federal Reserve Bank of Richmond
If you’ve read our Insights for any length of time you know that monetary policy, both domestic and abroad, has been responsible for many of the large trends in financial markets in the years since the global financial crisis. Policy makers have been incredibly accommodative, and our Federal Reserve has led the way. After cutting interest rates to zero in the wake of the subprime meltdown in 2008, the Fed embarked on a series of unconventional monetary policies in an effort to stimulate the economy and undergird the country’s financial system. We have covered these Fed programs exhaustively here on our blog, and we even sponsored the Colorado Springs screening of a related documentary called Money For Nothing, which was released in 2013 profiling the events.
But now we are entering a new phase of the Fed cycle. After nearly seven years of zero percent interest rates we are finally on the precipice of an interest rate INCREASE – or so it seems. If the last few years have revealed anything, it’s that trying to predict what the Federal Reserve is going to do next can make even the best and brightest among us look foolish. We do, after all, remember when the consensus was that the first rate hike would come in mid-2010! But despite the uncertainty, it is certainly true that current monetary policy will have to “normalize” at some point – and that means higher short-term rates are an eventuality.
Based on a variety of different economic indicators, it appears that the first rate hike could happen sooner rather than later. Perhaps even later this month. In light of this, we thought now would be a good time to dig into what all this rate hike talk really means. What is a “rate hike”, anyway? It’s something that we hear mention of on a daily basis in the media, so most of us understand that it’s coming and it’s something to be concerned about. But how many of us can actually articulate how a rate hike is accomplished, and what it means for the economy and markets? Let’s dig in.
When we talk about the Fed “setting interest rates” we are not talking about the prevailing rates on government bonds, mortgages or any other fixed income security – at least not directly. The Fed is an active participant in the open market for a variety of securities and through these open market operations they are able to exercise a large amount of control over the level of short-term rates. But when it comes to longer-term rates, their influence is much less direct. Thus, the Fed’s interest rate policy is really implemented on the short end of the curve, with some amount of trickle through effect on the rest of the debt market. Let’s take a look at how this is accomplished.
It all starts with the banks. For any minimum required level of reserves, a bank’s short-term (overnight) cash needs will fluctuate based on deposit and transactional activity during the day at that particular bank. Some days the bank will come up slightly short and some days it will have a little extra cash (called excess reserves) in relation to what it is legally required to have on hand. If a bank needs additional reserves at the end of a day to meet the minimum requirement, it can borrow on a short-term basis from another bank who has more than it needs. These overnight loans take place in a private market called the federal funds market, and the interest rate charged on these loans is called the fed funds rate, or simply the “funds rate”.
The funds rate is one of the most important interest rates in finance due to the fact that it acts as a baseline for all other interest rates charged by a bank. Money markets, mortgages, commercial loans, CDs, credit cards – they are all based to some extent off the level of the funds rate. Therefore, a higher funds rate should lead to higher prevailing rates on all types of debt throughout the economy, and vice versa. As such, when we talk about the Fed “setting interest rates” we are referring specifically to the funds rate. The Fed has a current target of 0-0.25% for the funds rate, which is what is meant by saying that the Fed has “set interest rates at zero” (see chart above).
So how does the Fed control the funds rate? Through open market operations. Quite literally, the Fed controls the funds rate by buying and selling government securities in the open market. By buying securities directly from a bank they replace that security with cash reserves on the bank’s balance sheet. In doing so, they have increased supply and reduced demand for reserves in the federal funds market thereby putting downward pressure on the rate charged on those reserves (the funds rate). In contrast, by selling securities in the open market they are replacing cash reserves with securities on a bank’s balance sheet, thereby reducing supply and increasing demand for reserves in the federal funds market and putting upward pressure on the funds rate. The Fed’s trading desk in New York is continuously operating in the open market in this fashion in order to keep the funds rate at or near its target.
There are a variety of other ways in which the Federal Reserve is active in the open market, but its influence over the funds rate is by far the most important. On the surface, it doesn’t make all that much sense why a small rate hike would create such volatility and hand-wringing in financial markets. The Fed is contemplating a small, marginal increase in the funds rate that will have very minimal immediate impact on the economy. That said, the first rate hike in the cycle is always seen as symbolic in nature as it represents the beginning of a shift to a more restrictive policy stance. In light of the sheer amount of accommodation central banks from around the world have provided markets in recent years, any shift by a major central bank such as the Fed is incredibly important. Consider the following statistic from Zero Hedge’s twitter feed:
A Fed rate hike really does signal the end of a period marked by extreme monetary policy accommodation. That said, much of the rest of the developed world will maintain a zero rate policy for quite some time, and the US Fed is likely to move extremely slowly as it transitions into the new hiking cycle. Thus, despite the fact that the looming rate hike will continue to be used as an excuse for a heightened level of fear and uncertainty in financial markets, we would expect it to become “yesterday’s news” in fairly short order once the Fed finally makes its move.
Author David Houle, CFA is a founding member of Season Investments. He serves as the firm's Chief Compliance Officer as well as sitting on the investment committee overseeing the management of client assets. David spent nearly ten years in various roles primarily managing individual client assets prior to co-founding Season Investments. David graduated with a degree in Finance from Colorado University in Colorado Springs in 2003 and earned the Chartered Financial Analyst (CFA) designation in 2006. David and his wife Mandy have three children and spend most of their free time with friends and family.
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