Fed Meets Again – Time To Raise Rates? The Clock Is Ticking

Wednesday, December 16, 2009

270669_where_in_the_time_is_carmen_saToday, the Fed announces its interest rate intentions. We will see if it continues to use its catch phrase: “… economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period,” leaving the federal funds rate unchanged.

I want to focus on that phrase: “exceptionally low.” In spite of that wording, the low rates have lasted so long, they are now treated as the new normal – hence the interest in buying bonds, even at their low yields. Here’s my view…

Expectations remain for a long, drawn out period of low rates. In spite of mounting, positive evidence for the economy, particularly among the leading indicators, the forecasts for slow growth in a fragile economy continue.

As importantly, the discussion of a change in Fed policy centers on the need to combat inflation. Because inflation rates are expected to remain stable and low, the reasoning goes, the Fed has no need to raise rates.

However, missing from the discussion is the fact that the Fed-controlled interest rates are abnormally low. In deciding to let rates rise, the Board would be easing off on the accelerator – not pushing the brake. I’d like to use an analogy to make the point clear:

To help solve a drought problem in a distant community, a reservoir dam’s floodgates are opened. Obviously, this is an abnormal activity that needs to be reversed at some point. As long as the floodgates are open at the dam, excess water will continue to pour through. The shutoff (i.e., the return to normal flow) needs to occur before downstream supplies return to normal because of the delay between dam and community.

For the Fed the distance from the dam to the community is a time measure. And the rule of thumb is that Fed actions taken now produce an effect six months out. So, we’re talking about June 2010.

Besides anticipating the future effect, the Fed also has to forecast what banks will be doing. Banks can create money through lending and will do so when economic growth takes hold, compounding money growth unless the Fed has already stepped back.

So, are we there yet? In spite of the steady-as-she-goes forecasts, I think so. But then, I thought so in October and again in November (see my October 28 write-up and November 4 update/comment: “GDP Report Could Alter Fed’s Monetary Policy”). Obviously, the Fed will raise rates sometime. The question is when; and that depends on the Fed’s comfort with its economy reading and forecasts of downstream effects.

* * *

By the way, there is a little discussed effect: the reduced income for savers and investors. This group deserves recognition for its contribution to the recovery effort. There is about $9 trillion in savings accounts, small time deposits and money market funds. As a result of Fed action, these funds are earning next to nothing. Each 1% below the normal interest rate level reduces these savers’/investors’ income by $90 billion. The lost income flows directly to the financial institutions and other short-term borrowers. I addressed this and other issues in my October 21 write-up: “Interest Rates Without the Fed – What’s ‘Normal’?

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One Response to “Fed Meets Again – Time To Raise Rates? The Clock Is Ticking”

  1. – UPDATE FROM JOHN TOBEY –

    No change was made in the federal funds rate today.

    The Federal Reserve Open Market Committee kept their economic language: “… economic activity has continued to pick up.” Compared to last month, they expanded on the improvements throughout the economy, including the labor markets.

    There was no change in the interest rate comments, with “exceptionally low” and “extended period” remaining:

    … economic conditions … are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

    The next FOMC meeting is January 26-27, 2010.

    #14

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