As someone who’s not very educated on the Federal Reserve, banking, etc, I am wondering what exactly it means when the Fed cuts interest rates. Interest rates on what? How does this effect the currency, or fend off recession?
Anyone that wants to correct me on any of the following is more than welcome to - I’m by no means an economist and it’s entirely possible I’ve missed some of the subtleties of what’s going on here but here goes (my best shot):
Commercial banks (that lend to businesses or people like you and me) need to maintain a certain amount of “reserves”. In the US, the reserve requirements are 10%, so for every $90 a bank lends out it needs to have $10 sitting on it’s books as reserves. When a bank doesn’t have enough reserves to justify the various loans that it has out, it needs to borrow in order to make up it’s reserve requirements… a process which is done on a daily (or nightly would be more appropriate) basis. They can borrow the money either from other banks or, if other banks don’t have the cash or aren’t willing to lend it, from the central bank. As such, the central bank is what’s often known as the lender of last resort.
The most common interest rate you hear quoted is the overnight cash rate (which is the rate that banks would borrow at to settle their accounts at the end of a business day). The central bank also makes various other kinds of loans available, which are typically for a fixed term (e.g. 14 days, 3 months etc.) and the interest rates on those other loans almost certainly won’t be the same as the overnight cash rate.
If banks are borrowing from the central bank at a lower interest rate then it typically means they’re able to loan that money out much more cheaply (since a lower cost of borrowing will lower their total overheads). If money is cheaper to borrow then people will be more inclined to take out loans, which increases the total amount of cash in circulation… which most governments around the world presently seem to be convinced “stimulates growth” - a claim which is tenuous at best.
It’s clear that there is some confusion on the basics of how the Federal Reserve works, so I’m going to provide a basic, undergraduate textbook explanation. I hope that those who have an in-depth understanding of its operations will forgive me for glossing over some of the details in the interest of simplicity.
There are three ways in which the Fed can control the money supply. The least often used is to change the reserve requirement. The reserve requirement is the minimum percentage of total assets that banks are required to have available at any given time. For example, if a bank has one million dollars in outstanding loans and the reserve requirement is 10% then the bank must have $100,000 in its vaults. If the Fed then lowers the reserve requirement to 5% then this bank can lend $100,000/0.05=$2,000,000.
The second way in which the Fed can control the money supply is by changing the interest rate charged by the discount window. This interest rate is known as the discount rate. The discount window is used by banks to borrow money overnight from the Fed. Returning to our example with the 10% reserve requirement, suppose that our bank had one million dollars in outstanding loans when a customer walked in who wanted a loan for $10,000. The bank knows that it will receive $20,000 in loan payments the next day in interest from its current customers but still can’t make this loan today without violating reserve requirements. The bank can borrow $10,000 from the Fed discount window today and pay it back with the interest received from its customers tomorrow. If the borrower requires an interest rate of 8% and the discount rate is 5%, the bank can make the loan and profit from the spread between the rate at which it is borrowing money and the rate at which it is lending money. If the discount rate is 10%, the bank will suffer an overnight loss as it will be borrowing money for more than it is lending it.
The third way in which the Fed can control the money supply is by changing the federal funds target rate. The federal funds target rate is the yield rate on short-term treasury bonds and treasury bills. The yield rate is a little different than an interest rate. When bonds are issued, they include a rate of interest that the bond issuer is obligated to pay. For example if a $100 bond had a 10% interest rate then the interest would be $10. The $100 is known as the par value. After the bonds are issued, however, they are bought and sold on the open market. If the consensus in the market is that the interest rate on the bond should actually be 12%, then the bond will trade at a discount to the par value. In this case, investors will pay $10/0.12=$83.33 for the bond instead of $100. If investors decide that the interest rate should be 8% the bond will sell at a premium, which in this case will be $125.
The Fed has a department, which is known as the open market committee, which buys and sells treasuries in order to control the yield rate. Their goal is to manipulate the yield rate so that it is equal to the Fed funds target rate.
Now, this next part can be a little tricky, so go back to my fourth paragraph if it confuses you. When the open market committee buys treasuries, they increase the demand and lower the yield. When they sell treasuries, they increase supply and decrease the yield. Since the Fed uses money to buy treasuries, Fed buying increases the money supply in the economy. When they sell treasuries, they receive money, which is withdrawn from the economy.
In the two most recent of Fed cuts, they cut both the discount rate and the federal funds target rate by the same amount. Cutting the federal funds target rate is more inflationary then cutting the discount rate, so the overall effect was more than what it would be if they had only cut one rate but less than twice the effect of just cutting the federal funds target rate.
Whoops, I made a mistake in my second to last paragraph. My point is that bond prices and bond yields go in opposite directions, so increasing the price by buying bonds decreases the yield, while decreasing the price by selling bonds increases yields.
As to fending off a recession, an increase in the amount of money increases investments. This works until either investors expect additional price inflation and build it into their analyses or the mal-investments pile up and cause an economic downturn.
Basically, a higher interest rate means the bond is cheaper, a lower one means it is more expensive.
Indeed - thanks for the excellent explanation. Can you recommend any reading that covers this in more detail?
All you need is right here: http://mises.org/books/fed.pdf
It’s also available in the mises store.
David:
The second question you have is “How does reducing the interest rate fend off recession.” Here is the Austrian perspective:
The lowering of interest rates allows consumers to get credit cheaper than it would otherwise. So consumers take this credit and go out and buy stuff with it. The amount of buying beyond what the consumer would do otherwise keeps businesses producing product and services through the recession when they would have not done so in the absence of the cheap credit. Suppliers/Businesses react to this buy hiring labor and building capacity. These are the positive short term effects. The trick is lower them enough to entice the consumer while avoiding the long term negative effects of the cheap credit.
In the long term things aren’t so good. The consumer gets cheap credit NOT WEALTH. The consumer at some point has to pay back the creditors. This can be hard on the creditees. The real issue that because consumers purchased things they would not have otherwise, suppliers/business reacted to this by building capacity they would not have other wise created. Now both parties are stuck. The consumer has debt requiring payback while the business built capacity that in the long run will not be profitable. There is not better example of this than the housing market. There is tons of extra capacity brought on by a consumer frenzy. Now whole neighborhoods are being liquidated as consumers refuse to buy new homes and the ones that are buying are not buying at the limits of their credit.
It’s an interesting book. It doesn’t actually talk much about the mechanics of the Fed - more of a history of how it came about according to Rothbard.
He has some excellent analogies at the beginning (where he’s talking about grain elevators).
After that he tends to rabbit on about the various motivations of all sorts of people (bankers, politicians and industrialists). Although many of these guesses as to what the motivations of the various people setting up the Fed might have been might well be correct, in my mind it’s almost a complete waste of time since:
a) You can’t possibly know what other people are thinking. Even when they tell you outright, half the time they’re either lying or incapable of accurately expressing it.
b) It really doesn’t change anything. If you’re a bum on the street and some lady gives you $100 bucks it’s $100 bucks whether she gave it to you out of pity, to impress the fella she was with or to relieve her conscience because she ran over another bum in her 4x4 the night before.
None the less, he probably accurately describes some of the effects (intentional or otherwise) of the various different changes that were made to the US banking system in the last few hundred years… one of the principal ones being, as Rothbard says, simply to facilitate and accelerate the rate at which both the Fed and the commercial banks can devalue the dollar and confiscate savings through monetary inflation. His ideas about central banks being essentially just tools to control and stabilize cartels that constantly found themselves being undermined in the free market are also pretty interesting - although he doesn’t talk too much about how this is achieved on an international level (he merely hints at the use of the World Bank and the IMF for these purposes).
All in all, certainly well worth the read - thanks.
What are some typically thoughts that might go through an investors mind such that he’d decide a bond should be worth 12% rather than 10%? Is that kind of dictated by inflation (e.g. inflation is 7% so I’ll only be making a real profit of 3% if I buy at $100) or is it more determined by other factors (such as conditions in the stock market or the housing sector)?
Generally, anticipated price increases only play a secondary role in investment decisions. Investors are always interested in getting the highest return for any given level of risk. If some other investment is yielding 14% but investors judge that the additional risk only justifies a 2% premium over treasuries, then they will either bid down the price on treasuries (until the yield increases from 10% to 12%) or bid up the price on the alternative investment until the yields are commensurate with the perceived risks.
If the value of the dollar is falling rapidly, however, investors will try to get their money out of dollar-denominated assets. They will probably spend more on consumption goods and put some of the remaining funds in inflation hedges, such as precious metals. In order to attract these funds back into stocks and bonds, the sellers of these securities must lower the prices, thus increasing yields.
In the case of treasuries, however, the Fed is buying securities, thus raising prices and decreasing yields. When this happens, investors who own treasuries can profit by selling them to the Fed and buying other securities, thus driving up the price and driving down yields. Consequently, the Fed is fighting free market forces in an attempt to keep stock and bond prices from falling. In the process, it is injecting more money into the economy, thus further exacerbating the rise in prices that caused the problem in the first place.
The above all sounds logical. However it also sounds like rather an oversimplification. The new money that gets created as a result of cheap credit won’t be showered evenly over the economy. It’s certain that, as with all inflation, it will find itself in the hands of some people before others. New money is, after all, not the creation of wealth but simply it’s redistribution. As such any new money that you might create and pour into, for example, the housing sector or the stock market may very well cause people in those sectors to spend where they would not have done so before and may well cause the businesses that they spend their money with to invest this “newfound capital” in increased production. Since the capital that is being invested in increased production for these businesses was necessarily confiscated from somewhere else, you’ll also see a corresponding decrease in production elsewhere in the economy…
Overall the result will no doubt be inflation and the central banks that created this hairy mess will then have to increase interest rates which will put the consumers and businesses that borrowed all that previously cheap credit in a pickle. As you say, at this point you have a problem in that borowers can’t afford the loans they took out and consumption drops off… and SOME producers find themselves with much more production capacity than is reasonable. However OTHER producers don’t have enough production capacity and you’ll see severe shortages of the goods that these later industries produce. So you have a mismatch of supply and demand across the board, which is hardly surprising because someone (and I wouldn’t want to be pointing fingers at the central bank at this point) was fiddling with the price indicators that producers and consumers use to communicate with one another. At this stage the central bank can do one of two things… they can continue to try to play god and print even more cash, attempting to inject this into the areas of the economy where there are now shortages (eventually if they keep this up they’d probably make Karl Marx proud) or they can finally admit that they’re a bunch of goons and let the recession, crash or complete economic meltdown run it’s course.
What they should do is recognize that the root of the whole problem is that they were fiddling with the prices in the first place and that the only way they can correct and even avoid this mess in the future is to adopt a sound monetary system that cannot be corrupted by the kind of short term thinking that is now the hallmark of central bankers and politicians.