The news following the mid-December meeting of the Federal Open Market Committee (FOMC) brought about what many predicted would have happened as far back as a year ago: after seven or so years of expansionary monetary policy, the Federal Reserve Bank (known simply as just The Fed) has decided to change course and introduce new policies to increase interest rates within the economy. While the coverage had dominated the media’s news cycle, many I have come in contact with have expressed bewilderment on a range of levels: Why did the Fed do this? What exactly is the Fed? What does the Fed actually do and how does it control interest rates throughout the economy? Should I be concerned over the latest new? I am sure that most who read this article will have the same questions because, in brute honesty, monetary economics and banking theory is really confusing . . . even for seasoned economists!
But why? The most general answer is because we, as a society, have made it that way. The United States has had a long history with distrusting centralized power. The entire three-branch/checks-and-balances structure of our government illustrates this fact. Similar distrust has always existed with a centralized banking system.
What is the Federal Reserve System?
Almost all developed (and developing) economies employ some variation on what is known as central banking: a single banking institution controls the economy’s money supply, supports commercial banks and manages monetary policy, specifically interest rates. Within the United States, central banking was presented as an alternative mechanism to the previous Free Banking system, where individual commercial banks each printed their own notes (financial jargon for paper money) and coins under a unified currency (i.e., the dollar). Take a look at a dollar bill of any denomination. Right at the top you will see it says “Federal Reserve Note” . . . but it did not always used to. For a long time, the commercial banking institution that printed the note had its own name on the bill. For example, dollars printed by Chase or J.P. Morgan would say “Chase Bank Note” and “J.P. Morgan Bank Note”, respectively.
The vast (and I do mean “vast” in the most explicit sense of the word) majority of macroeconomists, financiers and economic historians agree that the free banking system was a dismal failure in regards to economic stability. Panics, crises, money shortages, sudden and severe swings in inflation (the general rise in the prices of all goods and services) were ramped during the 1800s through the turn of the century, leading to the infamous “Panic of 1907”. For the American public on aggregate, the 1907 crisis was the final straw and the Federal Reserve Act of 1913 established the Fed with the primary mission of being the “lender of last resort”; that is, lending to commercial banks when crises arise (a mission that it very much failed twenty years later during the Great Depression).
In the spirit of decentralization, the Federal Reserve was created as a quasi-public organization (meaning it is both a private institution yet also part of the federal government as well) and split into a number of entities: the Federal Reserve Banks (12 regional banks in total; this was to ensure that the interests of the entire nation were considered and not just Washington and New York), the Board of Governors; the Federal Open Market Committee (FOMC), the Federal Advisory Board and member commercial banks (about a third of all U.S. commercial banks). While questions of how, who and why the Federal Reserve System is run the way it is goes beyond the scope of this article, it is important to know that when people discuss the “meeting of the Fed”, what they are really referring to when the FOMC has one of its eight (about every six weeks or so) yearly meetings. These meetings not only set the pulse of upcoming monetary policy and present the Fed’s view on the state of the macroeconomy, but are also used to decide the Fed’s decision(s) toward its influence on interest rates throughout the economy.
In other words: it is a really (REALLY) big deal.
How does the Fed “control” interest rates?
To shatter some rumors, it does not go around to different banking and financial institutions and regulate their rates . . . although it might like to. Avoiding much of the technicalities (again, beyond the scope of this article), the Fed’s influence on (short-term) interest rates throughout the economy is done using its control over the money supply and its buying/selling of government securities, most notably being Treasury Bonds or T-Bills.
Government bonds, like T-bills, are desired because they offer an investor an option that is devoid of any default-risk; that is, the possibility that the U.S. government will be unable to make its payments is basically zero because, if needed, it could either raise taxes and/or print more physical cash to do so. This fact makes the role of government bonds as a “base case” for all other investments: other investment options have to offer terms (read: interest rates/payments/discounts) better than the Fed/government. In addition, the discount/interest rate set on these bonds establishes the interest rate a commercial bank charges other commercial banks from borrowing their excess reserves (located at the Fed); this is known as the federal funds rate.
As an example, suppose that a one-month T-bill is offering a 10% return/interest rate. Given that these securities are devoid of any default-risk, an investor will only be interested in an alternative option if the rate of return, factoring in a number of other variables like probability of default and liquidity, is greater than 10%. If not, the investor is then better off with the government security. Therefore, as the interest rates on a T-Bills increase, so will all other market interest rates in the economy[i].
Neither the Fed nor the Treasury sets these T-bill rates explicitly. Instead, market mechanisms are employed to accomplish this goal. If the Fed wishes to see interest rates decrease, the FOMC will endorse the purchasing of securities from banking and financial institutions. By exchanging securities for physical money, there is an increase in physical currency circulating and the supply of loanable funds increases, causing the price on loans, or interest rates, to decrease[ii]. If the Fed wishes to see interest rates increase, the FOMC will endorse the selling of securities to banking and financial institutions. The exchange of physical money for securities decreases both the amount of physical currency circulating in the economy and the supply of loanable funds, causing interest rates to increase[iii].
Why does the Fed want to “control” interest rates?
Since the start of the Great Recession in 2007, the Fed/FOMC has been engaged in a program of constantly purchasing securities to keep interest rates in the economy down. Given the severity of the recession, the seven-year purchasing policy drove the (short-term) Fed interest to basically zero. Why? A cruel cycle tends to play out during periods of recession: consumers buy fewer goods and services causing firms to decrease their production; decreased production means fewer workers are needed; the decreased need for labor decreases consumer income and even fewer goods and services are purchased; and so the cycle continues. To fight such a recessionary trap, the Fed aims to lower interest rates in order to accomplish three main goals: (i) incentivize households to consume rather than save (lower interest rates also means lower rates on bank deposits by consumers); (ii) incentivize households to increase their borrowing and debt-spending to purchase “real assets” like automobiles and houses; and, (iii) incentivize firms to borrow more (due to the cheapening price of loans) and expand the production schedule.
With the December meeting’s decision to slowdown the purchasing of securities, the Fed is essentially saying that the economy is healthy enough to start functioning without the proverbial training wheels. The two most important reasons the Fed offers to support this belief is the decreased unemployment rate (now at 5%; what economists label as “full employment”) and the steady — although, at times, not the most reassuring — economic growth over the past couple of years. By slowly increasing interest rates now when the economy can handle it, the Fed can avoid a (possible) future catastrophe when it must drastically raise rates due to economic turmoil[iv].
Dissenters are, as one would expect, abound. Some believe that the move is too soon, especially given the stagnation of wages. When unemployment rates decrease, wages normally increase to reflect the decreasing size of the available labor supply pool. This has not happened as of yet. Others suspect that ideology and politics are at play. There are some who existentially disagree with the fundamentals of how the Fed functions, especially in regards to the policy of quantitative easing (the purchasing of securities to drive interest rates in the economy down). The Fed was under pressure with its purchasing policy since its inception in 2007 . . . and that pressure has only accelerated since the economic outlook became brighter.
How does all this affect me?
Regardless of their motivations or whether they are correct in their policy change, the fact remains that the Fed will be increasing the interest on government securities. We can now get to answer the MAIN question on many minds: how is this going to affect me?
Even with its modest quarter-of-a-percent (0.25%) increase in T-Bill rates, the Fed is effectively causing an increase in all other interest rates. For starters, there will be less physical currency circulating and the supply of loanable funds will decrease. Therefore, the price on a loan will start to increase and one should expect (probably in the next few months) increases in interest rates on all types of loans: automobile, credit card, payday, mortgage, short-term and long-term investment loans, non-government student loans and so on. In fact, given the decrease in the supply of legitimate loanable funds, alternative markets, such as “loan sharking”, will possibly experience an increase in demand and see increased interest rates as well!
Lending institutions are the most excited to see interest rise. Banks can now not only charge more for loans (and increase profitability), but it also allows them to be a bit more competitive in the market; that is, individual banks have more market power in how and what they set their prices at. The bond market is, by consensus, the most vulnerable to interest rate changes due to rating-status pressures. Non-interest bearing commodities, like gold, silver or sugar, will in turn see a decrease in demand and value because other interest-bearing investment opportunities become more attractive (With the price on an ounce of gold and silver decreasing in the future, one should also expect zakat calculation and payments to be affected). In regards to currency trading, your guess is as good as mine!
One might retort that, as a Muslim, interest rates on various types of loans has no affect them because it is deemed haram and they have no dealings with them. Beyond the fact that this is a minority case for those of us living in the west, there are other macroeconomic consequences of interest rate hikes to consider. Do to the increased price of borrowing, businesses will have an increased disincentive to take out loans and production of goods and services in the economy will begin to slow. As a result, hiring and wage rates may begin to slow down as well. In addition, the increasing interest rate on deposits will motivate many households to begin saving more and spending less. Hence, businesses will experience less commerce and, again, begin to slow down its production schedule.
This is not to say that the Fed’s action is going to start pulling the economy down back into a recession; only that they believe the economy is strong enough to grow on its own. Interest rates will still be at historically unprecedented levels and, as many would argue, they have to increase eventually. Is panic necessary? Not in the slightest. Chairman Yellen has been very vocal in the Fed’s plan to have interest rate increases done at a very moderate pace.
In the end, Allah knows best.
[i] Two important points should be noted here. First, the assumption that government securities have a zero probability of default is only true in cases where these securities rated to the highest caliber (AAA, for example). This is true for many developed economies like the U.S., but it is not universal. Second, government securities are discount bonds and do not really pay an explicit interest rate per se. Instead of offering an interest rate, they are sold at a less-than-face value price with the agreement that they will be purchased at face value at the time of maturity. For example, suppose that a one-month T-bill has a face value of $100 but is sold at $90. The purchaser is buying the security at a discounted price and, in a month’s time, will have earned $10 on the sale.
[ii] A more technical explanation: by purchasing securities, the Fed is decreasing the supply of T-Bills in the economy and causing their price to increase. As the price of a bond increases, the associated interest rate on the bond decreases.
[iii] While the Fed is commonly referred to as “buying” or “selling” securities”, it actually does none of the buying or selling. At the Fed/FOMC’s instruction, these sales are conducted by outside dealers in the industry.
[iv] This rationale has been heavily criticized by a number of economic heavy weights, including Larry Summers.