By: Tim Hayes Financial Advisor - posted in: Investing - Last updated Nov 29, 2018

Financial Advisor Blog

Articles are about big issues affecting readers, individual or corporate.

Are Interest Rates Heading Up?

by | Investing

The Federal Reserve, a.k.a. “the Fed,” has kept the federal funds rate at zero for seven years now. But after a strong monthly jobs report in October, where the economy created 271,000 new jobs and the unemployment fell to 5%, the Fed may finally be ready to raise it.

During those seven years, people paid an average of 15% on their credit cards and 4% on their 30-year mortgages. And today, a loan to buy a new car will cost you around 4%. So it was only the federal funds rate— the rate at which banks borrow reserves from other banks. —that was at set at zero. “Banks borrowing?” you may ask. “I thought banks just lent money!” They do both.

The Fed Is Where Banks Deposit Money

Those deposits, which are called reserves, are the means by which banks pay other banks. Before the financial crisis of 2007-08, banks did not earn interest on reserves, so they deposited what was required by law: $43 billion, plus another $1.9 billion in excess reserves. Moreover, this $45 billion in total reserves was somehow able to circulate among banks and support trillions of dollars in payments.

For example, say your bank is Wells Fargo, and you write a check for $2,500 to your car mechanic, who happens to bank at Citi. Wells deducts $2,500 from your checking account, and then transfers $2,500 from its reserve account at the Fed to Citi’s reserve account. Then Citi increases the mechanic’s checking account by $2,500. No actual cash moves; it is all done electronically. And when some banks were short of reserves, they could always borrow them from other banks.

However, in 2008, the healthier banks stopped lending their reserves to the failing banks, and the payment processing system was on the verge of collapse. To make sure people’s mortgage and car payments were processed, the government bailed out the failing banks. This gave the healthier banks the confidence they needed to lend failing banks reserves again and prevented interruption of the payment processing system, which would have stopped commerce and caused another Great Depression.

Quantitative Easing

After the government stabilized the banks, and with the fed funds rate already lowered to zero, the Fed embarked on a stimulus program (quantitative easing) through which it bought long-term bonds from banks, which the Fed paid for by crediting the banks with reserves. The Fed bought so many bonds that reserves went from $45 billion in 2008 to $2.6 trillion today.

Historically, when the Fed wanted to raise rates, it would sell bonds to banks, which the banks would pay for with reserves. This drained reserves from the banking system, so the cost to borrow the remaining reserves would go up. Banks would then try to pass their higher borrowing costs onto their customers by charging them higher rates on mortgages, car loans, business loans, etc.

Today the Fed has a no way of quickly draining those $2.6 trillion of reserves. So, to raise the federal funds rate, the Fed will now have to pay banks interest on their reserves. If not, there would be a stampede of banks wanting to lend their excess reserves to other banks causing any recently raised federal funds rate to fall back to zero.

In 2009, in anticipation of this dilemma, some members of the Fed discussed getting rid of all those excess reserves by selling the bonds back to the banks. However, instead of selling bonds, the Fed over the next few years bought trillions of dollars more.

Impact of Rising Interest Rates on Bonds

When there is talk of rates going up, people and companies that consider borrowing money tend to speed up their decision-making processes to lock in the lower rates. Investors who own a lot of bonds in their portfolios also get anxious because, when rates go up, the value of their bonds starts to go down.

But the interest rate policy of the Federal Reserve is but one variable in an economy full of variables. So there is no guarantee that commercial banks will be able to pass their higher borrowing costs onto consumers and businesses—especially if the slowdown of the gross domestic product in the third quarter of FY 2015 continues.

However, the Fed knows it must get the federal funds rates off of zero. If the economy were to fall back into a recession and the rate was still at zero, the Fed’s only policy tool would be the unpopular bond-buying program, quantitative easing.

The Fed probably should have raised the fed funds rate last year. Instead, what is likely now is that a slowing economy and tame inflation will put the Fed in the unenviable position of having to pay banks interest to slow an already slowing economy.

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