Foss: Quo Vadis, Federal Reserve?

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Foss: Quo Vadis, Federal Reserve?

September 16, 2015

Paul-Martin Foss of the Menger Center for Money and Banking writes

While many had hoped that the Jackson Hole summit in late August would provide some clarity on the direction the Fed would take with regard to the federal funds rate, they were left sorely disappointed. The Fed enters its FOMC meeting this week with economists firmly and evenly divided between those who think the Fed will raise rates this week, and those who think it won’t. And judging by some of the public statements of the regional Fed Presidents, it appears that even the Fed itself is split on whether or not to begin raising interest rates. So what will the Fed end up doing?

There are a number of possibilities. The most likely in my opinion is that the Fed will continue to keep the federal funds rate at the September meeting at between zero and one-quarter point. Despite all the chatter about the Fed raising interest rates, it’s far from clear that there is a consensus among the 10 members of the FOMC to raise rates. If the Fed votes to keep rates unchanged, expect a dissenting vote from Richmond Fed President Jeffrey Lacker, and possibly a dissent from Atlanta Fed President Dennis Lockhart. The other two non-New York regional Fed Presidents, Charles Evans of Chicago, and John Williams of San Francisco, are doves, and I just can’t see enough determination on the part of the Fed governors to push through a rate increase at this meeting. Yellen has been silent, Fischer appears to be waffling, and the other three haven’t expressed any strong support for a rate hike. But neither do they have the backbone to override Yellen if she decides a hike is in order. However, the FOMC has expressed so much hesitation to raise rates that with the recent turmoil in China and the continued lackluster growth of the US economy, I believe that the committee will continue to kick the can down the road.

If the Fed decides to raise the federal funds rate, I would expect it to be raised to 50 basis points (one-half a percentage point). Since the effective daily federal funds rate fluctuates between 8 and 15 basis points, this is effectively a 35-40 basis point rate increase. Raising the funds rate to 75 basis points would be a little much for a first step, although it’s still possible. But both an increase to 50 or to 75 give the Fed the option to drop the federal funds rate by 25 basis points at future meetings in the event that markets react badly to a rate increase. The Fed wants to keep that option open, to give itself a little breathing room, without looking like it is completely backtracking on its commitment to a rate rise.
Finally, the Fed could engage in more quantitative easing. That obviously won’t happen at tomorrow’s meeting, but don’t be surprised to see it happening in the future. Let’s face it, even raising interest rates to one percent is an incredibly low rate and indicative of an easy monetary policy. And the Fed will continue to roll over its maturing securities and invest interest received into purchases of new securities, so the balance sheet will continue to increase. There is no monetary tightening that will be occurring, only a slowing of the rate of monetary easing.

The Fed is a one-trick pony. All it knows how to do is create more money when it thinks that the economy is in danger of a downturn. That is its purpose. Tightening monetary policy, when to tighten, how to tighten, etc., is something with which it is far less comfortable. The Fed created the last bubble and reacted to its bursting by turning on the monetary spigots. Now with a balance sheet of $4.5 trillion, it has created an even larger bubble and it will react to the next downturn in the same way, by pumping more money into the system. QE4 is a question of when, not if. Expect the Fed to screw things up even further in the future, no matter what the FOMC decides to do tomorrow.

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