Economic reasons for rate increase by the Fed?

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cj2018
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Economic reasons for rate increase by the Fed?

Post by cj2018 » Wed Sep 26, 2018 4:48 pm

As expected by market, the Fed raised interest today and signaled another one in Dec. It got me thinking:
  • What's the main economic rationale for manually adjusting interest rates?
The reason why I'm wondering this are the following:
  • In a free market, shouldn't rates determined by the supply/demand of available capital/savings and expected rate of return on potential investment opportunities demanded by the market participants?
  • In a free market, shouldn't banks constantly assess market conditions and adjust their lending standards/criteria and consequently rates they can offer to customers in order to stay competitive and win business from borrowers?
I guess I just fail to understand why every time when economy is strong and commerce/trade are booming, Feds decide to "always" increase rates and conversely, "always" decrease rates when economy is weak, when that function should be performed by the free market and in my mind can either go up or down depending on economic situation at the time. Any BHs who's knowledgeable about free market economy, please school me :)

PS: To avoid breaking forum rule and having admin locking this thread, please stay clear of any conspiracy theories (Fed being unconstitutional, private, gold, fiat currency, banking cartel, crashing economy and harvesting etc.) and stay on topics on the economic reasons of rate increase/decrease from Fed, thanks.

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bottlecap
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Re: Economic reasons for rate increase by the Fed?

Post by bottlecap » Wed Sep 26, 2018 4:55 pm

The short answer is because politicians, the Fed, and many economists believe that they can successfully reguate the economy through such measures and eliminate (or "smooth out") booms and busts.

It just doesn't work well in practice.

JT

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Re: Economic reasons for rate increase by the Fed?

Post by SoonerD » Wed Sep 26, 2018 5:00 pm

cj2018, perhaps you will answer your own questions if you clarify which interest rate was increased by the Fed. Is it the same thing as the interest rates that are determined by the banks?

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Artsdoctor
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Re: Economic reasons for rate increase by the Fed?

Post by Artsdoctor » Wed Sep 26, 2018 5:04 pm

There are multiple reasons. You can find plenty of descriptions on this throughout the internet financial pages. You can start with today's news and work backwards, depending on your baseline knowledge:

https://www.nytimes.com/2018/09/26/us/p ... e=Homepage

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Re: Economic reasons for rate increase by the Fed?

Post by TigerNest » Wed Sep 26, 2018 5:05 pm

The Fed sets the nominal, short-term interest rate, but the real interest rate is set by market forces and the state of the economy. The Fed needs to periodically adjust the nominal rate so it's in equilibrium with what they estimate is the real interest rate, otherwise the economy will slow or it will cause inflation.

Ben Bernanke has an excellent blog that describes some of these forces at work. I'd encourage you to read one of his first posts, Why are interest rate so low: https://www.brookings.edu/blog/ben-bern ... es-so-low/

Ben Bernanke:
If the Fed wants to see full employment of capital and labor resources (which, of course, it does), then its task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or—more realistically—its best estimate of the equilibrium rate, which is not directly observable. If the Fed were to try to keep market rates persistently too high, relative to the equilibrium rate, the economy would slow (perhaps falling into recession), because capital investments (and other long-lived purchases, like consumer durables) are unattractive when the cost of borrowing set by the Fed exceeds the potential return on those investments. Similarly, if the Fed were to push market rates too low, below the levels consistent with the equilibrium rate, the economy would eventually overheat, leading to inflation—also an unsustainable and undesirable situation. The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.
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Last edited by TigerNest on Wed Sep 26, 2018 5:18 pm, edited 1 time in total.

Dave55
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Re: Economic reasons for rate increase by the Fed?

Post by Dave55 » Wed Sep 26, 2018 5:09 pm

The Fed does not want the economy "to overheat" because in the past that has led, or can lead to high inflation. They are attempting to moderate economic growth, so its not too much, nor is it too little.


Dave

alex_686
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Re: Economic reasons for rate increase by the Fed?

Post by alex_686 » Wed Sep 26, 2018 5:11 pm

cj2018 wrote:
Wed Sep 26, 2018 4:48 pm
  • In a free market, shouldn't rates determined by the supply/demand of available capital/savings and expected rate of return on potential investment opportunities demanded by the market participants?
  • In a free market, shouldn't banks constantly assess market conditions and adjust their lending standards/criteria and consequently rates they can offer to customers in order to stay competitive and win business from borrowers?
First, there is a difference between "should" and "can". There is a long and delightful history of bank failures where banks have failed because they did not judge risks correctly. For a variate of reasons, contagion then kicks off, with bad banks taking down good banks. There is a asymmetric risk here - heads I win, tails everybody loses.

Second, a free market assumes that there is a free exchange. Free exchange implies that the buyer and seller have roughly equal power and responsibility. i.e., no bullying by one side. Once again history has lots of examples where this is not true.

America prior to the Federal Reserve is fascinating history. Lots of boom and bust cycles. Lots of exploitative behavior.

I buy into the "Credit Theory" of money, where money is a very special type of debt. It is a social construct. The value of money is that society says it has value. Banks can more or less print money. Should we leave that power unregulated? It is the fed that regulates this power and one of there levers is the interest rate.

I will point you to the excellent book Money: The Unauthorised Biography by Felix Martin.

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Re: Economic reasons for rate increase by the Fed?

Post by alex_686 » Wed Sep 26, 2018 5:15 pm

bottlecap wrote:
Wed Sep 26, 2018 4:55 pm
The short answer is because politicians, the Fed, and many economists believe that they can successfully reguate the economy through such measures and eliminate (or "smooth out") booms and busts.

It just doesn't work well in practice.

JT
I will take the counter-side of that argument. The Fed has more or less abounded "fine tuning" the economy, for more or less the reasons you point out. They are now more focused on price stability. They sorta of want to lean against bubbles and irrational exuberance, but they also admit that they powers here are fairly feeble.

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Re: Economic reasons for rate increase by the Fed?

Post by beardsworth » Wed Sep 26, 2018 6:01 pm

The principle was most succinctly and humorously stated by William McChesney Martin, chairman of the Fed for most of the 1950s and all of the 1960s, who said that it's the Fed's job "to take away the punch bowl just as the party gets going."

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Re: Economic reasons for rate increase by the Fed?

Post by dm200 » Wed Sep 26, 2018 6:06 pm

bottlecap wrote:
Wed Sep 26, 2018 4:55 pm
The short answer is because politicians, the Fed, and many economists believe that they can successfully reguate the economy through such measures and eliminate (or "smooth out") booms and busts.
It just doesn't work well in practice.
JT
Others have different opinions and conclusions.

adamthesmythe
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Re: Economic reasons for rate increase by the Fed?

Post by adamthesmythe » Wed Sep 26, 2018 6:07 pm

We don't have a totally free market. Nor do we have a totally controlled or command economy.

Immediately prior to the Great Depression, we were a good bit closer to a free market. It didn't work out so well.

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Re: Economic reasons for rate increase by the Fed?

Post by DavidRoseMountain » Wed Sep 26, 2018 7:46 pm

A healthy amount of inflation is good for the economy because it makes debt worth less, and therefore permits the burden of that debt to become less onerous over time.
IF the Federal Reserve raises interest rates too much too quickly then inflation stays low for too long and the debt burden continues on as a drag that prevents more consumption/demand.

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bottlecap
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Re: Economic reasons for rate increase by the Fed?

Post by bottlecap » Wed Sep 26, 2018 8:40 pm

dm200 wrote:
Wed Sep 26, 2018 6:06 pm
bottlecap wrote:
Wed Sep 26, 2018 4:55 pm
The short answer is because politicians, the Fed, and many economists believe that they can successfully reguate the economy through such measures and eliminate (or "smooth out") booms and busts.
It just doesn't work well in practice.
JT
Others have different opinions and conclusions.
Of course they, and you, do.

But I'd like to take a moment to introduce you to the Great Depression. And the go-go Sixties. And stagflation in the Seventies. 1987. Heck, Japan. The exuberant Nineties. The tech crash of 2000. And the Great Recession.

The opinions may be different, but the conclusion is undeniable. The Fed can’t predict the economy any more than a Boglehead. If it can't do that, it will continue to fall short.

I wish it could. We'd all be eating rainbow stew.

But alas, this is reality.

JT

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Re: Economic reasons for rate increase by the Fed?

Post by arcticpineapplecorp. » Wed Sep 26, 2018 9:01 pm

There is a theory that rates could be better set by an automatic system (type of algorithm if you will) that has been devised (and backtested) by John Taylor of Stanford University. His set of rules is outlined in what's been known as "The Taylor Rule". You can listen to him discuss the particulars of how a system would automatically adjust rates at a fine interview done by Russ Roberts on his podcast econtalk:

http://www.econtalk.org/john-taylor-on- ... ylor%22%5D

In the spirit of even-handedness, there's also another podcast at econtalk that's called "What's wrong with the Taylor Rule":

https://www.econlib.org/library/Columns ... ylor%22%5D

Even Milton Friedman has weighed in (think it was part 2 interview below):

https://www.econlib.org/library/Columns ... dman%22%5D

Friedman was not overly convinced this was the way to go despite having concerns about how the decisions are made to increase/decrease the money supply by a group of humans which by definition are fallible.

By the way, John Taylor was actually on the short list of nominees President Trump considered for the latest Fed Chief (the job instead went to Jerome Powell).
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Re: Economic reasons for rate increase by the Fed?

Post by Elbukari » Wed Sep 26, 2018 9:07 pm

cj2018 wrote:
Wed Sep 26, 2018 4:48 pm
  • What's the main economic rationale for manually adjusting interest rates?
There is a free Yale Course - Foundations of Financial Markets and Institutions- that I am taking at my own pace. The textbook is quite long and can be difficult at times but I have been taking notes along the way, so I am hoping to put some of my knowledge to good use here.

To answer your question in simple terms, the Federal Reserve manually adjusts interest rates in hopes of regulating economy to prevent over inflation, deflation or stagflation. The 2% interest rate is not a scientifically based number, just something that they've come to realize has worked relatively well so far in preventing extremes and allowing for a growing economy at a sustainable rate.

The reason why I'm wondering this are the following:
  • In a free market, shouldn't rates determined by the supply/demand of available capital/savings and expected rate of return on potential investment opportunities demanded by the market participants?
Yes, but this is not a free market by definition. This is state capitalism. There is certainly a great degree of freedom for institutions and individuals to express their creative ideas, innovate, and interact in the market, but there is always a degree of state involvement to prevent the big guys from taking advantage of the little guys. By definition we do not live in a truly free Capitalistic society.
  • In a free market, shouldn't banks constantly assess market conditions and adjust their lending standards/criteria and consequently rates they can offer to customers in order to stay competitive and win business from borrowers?
Again, the answer is a yes in a free market.
____________________________

Whether our economy should run in such a way is up for debate. There are examples on both sides of the argument where the economy would do better under different conditions. Certainly in recent history we have seen investment banks and financial institutions fail, requiring the Federal Reserve to act as a lender of last resort to the bank system to avoid a financial crisis.

The big idea behind the Federal Reserve is of course to stabilize the currency (we have to keep in mind that we are an open economy interacting in international markets with different currency values; you want the US dollar to survive) and controlling the money supply to avoid extremes of inflation or deflation. Many argue that the Fed should in fact operate individually and without the influence of the White House or Congress to avoid making decisions in the economy at the expense of inflation. Whether this occurs or not is certainly debatable.

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Re: Economic reasons for rate increase by the Fed?

Post by adam1712 » Wed Sep 26, 2018 9:25 pm

I think it's important to realize that if the government is going to print and supply money, there has to be some control over how much. The Fed is directly affecting the supply of money when they set a target interest rate. There's plenty of arguments about whether manually is the best way and what principles should be used. Or should there be more set rules. But there has to be some type of "Fed" rather than only private banks if there's going to be a central currency.

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Re: Economic reasons for rate increase by the Fed?

Post by boglerdude » Thu Sep 27, 2018 1:41 am

The Fed changes the money supply and that causes the banks to change rates. They dont like to phrase it that way because it's illegal (for you) to print money.

These days they pay the banks interest on reserves instead. Is this a subsidy?

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JoMoney
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Re: Economic reasons for rate increase by the Fed?

Post by JoMoney » Thu Sep 27, 2018 2:29 am

Our money supply is not a "free market". It is heavily managed, and it's managed with a mandate to maximize employment, stabilize prices, and moderate long-term interest rates.
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Economic reasons for rate increase by the Fed?

Post by Valuethinker » Thu Sep 27, 2018 3:47 am

cj2018 wrote:
Wed Sep 26, 2018 4:48 pm
As expected by market, the Fed raised interest today and signaled another one in Dec. It got me thinking:
  • What's the main economic rationale for manually adjusting interest rates?
The reason why I'm wondering this are the following:
  • In a free market, shouldn't rates determined by the supply/demand of available capital/savings and expected rate of return on potential investment opportunities demanded by the market participants?
Which is broadly what happens, because the Fed does not directly set market rates. Look at the Financial Crisis. Central Banks lowered their reference rates. LIBOR, which although set in London is used by US banks (the USD LIBOR rate) stayed stubbornly high.
  • In a free market, shouldn't banks constantly assess market conditions and adjust their lending standards/criteria and consequently rates they can offer to customers in order to stay competitive and win business from borrowers?
All the pre 1929 evidence suggests that they do so with great instability. After JP Morgan personally stopped the crash of 1907, it was decided that one could not leave the stabilization of the system up to the private banks, alone - JPM as a financier was so far above any of his peers that he could do this. Not even John Reed at Citigroup in the day, or Jaime Diamond at JP Morgan now, could do that alone.
I guess I just fail to understand why every time when economy is strong and commerce/trade are booming, Feds decide to "always" increase rates and conversely, "always" decrease rates when economy is weak, when that function should be performed by the free market and in my mind can either go up or down depending on economic situation at the time. Any BHs who's knowledgeable about free market economy, please school me :)
The problem is one of inflation. Inflation would then run away. Losing control of inflation, as it did in the 1970s, turned out to be a painful experience. The cost of bringing inflation back under control in the early 1980s was brutal - 21% interest rates and soaring unemployment, etc.

There is also the risk of uncontrolled deflation as happened in the early 1930s, and that has grievous economic consequences for GDP and employment, because wages and prices are "sticky downward". This stickiness takes a nominal shock and makes it a real (output) one. If we all agree to lower all our prices and wages from 100 to 90 then there's no fundamental change in the economy. But if some of us only lower our prices and wages to 95, say, then others must lower theirs to 85. The practical result is massive unemployment and lost output (GDP).
PS: To avoid breaking forum rule and having admin locking this thread, please stay clear of any conspiracy theories (Fed being unconstitutional, private, gold, fiat currency, banking cartel, crashing economy and harvesting etc.) and stay on topics on the economic reasons of rate increase/decrease from Fed, thanks.
You have your answer.

Note that under Bretton Woods (1945-1971) the Central Bank was also responsible for setting the exchange rate (in liaison with the Treasury, at least in the UK). A fixed exchange rate system requires Central Bank intervention. Countries then require currency controls - China does now, to maintain its pegged renimbi exchange rates.

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Re: Economic reasons for rate increase by the Fed?

Post by Valuethinker » Thu Sep 27, 2018 3:49 am

DavidRoseMountain wrote:
Wed Sep 26, 2018 7:46 pm
A healthy amount of inflation is good for the economy because it makes debt worth less, and therefore permits the burden of that debt to become less onerous over time.
IF the Federal Reserve raises interest rates too much too quickly then inflation stays low for too long and the debt burden continues on as a drag that prevents more consumption/demand.
That's nominal debt.

In an efficient economy, much more debt would be denominated in real terms. Mortgages, for example, would have a constant real rate rather than a constant nominal rate.

The problem is money illusion is quite a real thing. Investors and borrowers would not understand the product.

The use of inflation to randomly hand out winners & losers between debtors and creditor is a fairly blunt instrument of redistributive policy and does not really help the most vulnerable (who have no real assets like stocks or property, may not even have a bank account). In effect, it's a way of avoiding a debt writeoff but one is doing it in a way which is totally arbitrary. There's no reason why the biggest borrowers should get the most debt relief.

Inflation of 2% is probably tolerable. Once you get much above say 3% the costs of bringing it back down start to grow. No one who remembers the late 1970s or early 1980s thinks uncontrolled inflation is a blessing.

Arguable risk aversion is extreme - the risk free US government debt is overpriced. Thus, it suits society's interest to have some inflation, to correct for that. But a lot of inflation simply wipes out trust in the government and encourages speculative behaviour.
Last edited by Valuethinker on Thu Sep 27, 2018 4:06 am, edited 2 times in total.

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Re: Economic reasons for rate increase by the Fed?

Post by Valuethinker » Thu Sep 27, 2018 3:51 am

boglerdude wrote:
Thu Sep 27, 2018 1:41 am
The Fed changes the money supply and that causes the banks to change rates. They dont like to phrase it that way because it's illegal (for you) to print money.

These days they pay the banks interest on reserves instead. Is this a subsidy?
No one can find a useful measure of money supply.

The modern banking system is too innovative. It creates new forms of uncontrolled money if you try to target any particular monetary aggregate.

M1, M1b, M2, M3, M4 - have seen them all created, targetted and eventually abandoned. Some of those stats are not even produced any more.

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Re: Economic reasons for rate increase by the Fed?

Post by Call_Me_Op » Thu Sep 27, 2018 7:01 am

The Fed has a dual mandate - maintain full employment and keep inflation close to 2%. The rate that the Fed sets for overnight borrowing of bank/credit union reserves in one of the levers they have to help meet the dual mandate, thus they use that lever. Note that this will determine very short term interest rates, but the effect this has on longer-term rates decreases with increasing maturity.
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Re: Economic reasons for rate increase by the Fed?

Post by Phineas J. Whoopee » Thu Sep 27, 2018 8:05 am

JoMoney wrote:
Thu Sep 27, 2018 2:29 am
Our money supply is not a "free market". It is heavily managed, and it's managed with a mandate to maximize employment, stabilize prices, and moderate long-term interest rates.
Those are indeed the statutory objectives of the Federal Reserve System, as mandated by Congress which created the Fed.

PJW

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Phineas J. Whoopee
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Re: Economic reasons for rate increase by the Fed?

Post by Phineas J. Whoopee » Thu Sep 27, 2018 8:16 am

Hi OP.

Your question is one for books, debates, conferences, varying opinions, and sometimes shouting matches. I won't attempt to post all of them at once.

You did not show a misunderstanding of what the Fed did, but just to be clear, especially for others who may come across this thread, the Fed changed the target rate for overnight loans of reserves among banks. The Fed does not control interest rates, plural. The rate it changed the target for is the Federal Funds Rate, which doesn't apply to you and me unless you and I are both licensed commercial banks.

Bank loan and deposit rates are set by individual commercial banks themselves, and reflect their need for funds or for profitable loans.

Bond yields are set by an ongoing, continuous auction in the marketplace.

PJW

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patrick013
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Re: Economic reasons for rate increase by the Fed?

Post by patrick013 » Thu Sep 27, 2018 12:15 pm

There are certainly some differing economic interpretations
in the papers. Here's one clip describing the higher expectation.

"In its updated outlook Wednesday, the Fed foresees one final
rate hike after 2019 — in 2020 — which would leave its benchmark
at 3.4 percent. At that point, it would regard its policy as modestly
restraining growth. The Fed seeks to slow the economy when it
reaches full employment to prevent a tight job market from raising
inflation too high."

Inflation is caused by growth, taxes, and high interest but I don't
think that is the problem. There is an equilibrium interest rate
but it isn't 0 or 1% or 10 or 12%, it's somewhere in the middle.
Raising rates will limit production and lower overproduction
while giving the consumer added surplus to buy things. A smoother
economy should result. Most corporate earnings gains are due
to the reduced taxes so growth already appears slower. But
infinite growth isn't possible anyway. Economists usually agree
a medium interest rate is best. The averages are also much higher.
age in bonds, buy-and-hold, 10 year business cycle

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Re: Economic reasons for rate increase by the Fed?

Post by Boglegrappler » Thu Sep 27, 2018 12:28 pm

One of the largest reasons for the recent rate increases is that the Fed has only a couple of tools at its disposal. The use of "quantitative easing" in the past years amounts to printing money to buy securities, and that's something that they're not particularly comfortable with.

The Fed much prefers pushing around the short end of the credit market. But with rates where they were two years ago, they are essentially out of ammunition to protect against the next downturn. Getting short rates up off the ground creates some space for them to react to the next recession by lowering rates.

IMO, that is the biggest reason for raising rates currently. Its to recover the utility of one of your basic tools.

longleaf
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Re: Economic reasons for rate increase by the Fed?

Post by longleaf » Thu Sep 27, 2018 12:31 pm

bottlecap wrote:
Wed Sep 26, 2018 8:40 pm
dm200 wrote:
Wed Sep 26, 2018 6:06 pm
bottlecap wrote:
Wed Sep 26, 2018 4:55 pm
The short answer is because politicians, the Fed, and many economists believe that they can successfully reguate the economy through such measures and eliminate (or "smooth out") booms and busts.
It just doesn't work well in practice.
JT
Others have different opinions and conclusions.
Of course they, and you, do.

But I'd like to take a moment to introduce you to the Great Depression. And the go-go Sixties. And stagflation in the Seventies. 1987. Heck, Japan. The exuberant Nineties. The tech crash of 2000. And the Great Recession.

The opinions may be different, but the conclusion is undeniable. The Fed can’t predict the economy any more than a Boglehead. If it can't do that, it will continue to fall short.

I wish it could. We'd all be eating rainbow stew.

But alas, this is reality.

JT
Depression sort of triggered the government stepping in, so I don’t really expect a drop of that severity again. But, as you stated, the government cannot prevent a drop from happening, and it could very well exceed that of the depression. New laws are made with each incident, so macroeconomics is learning!
Frugality, indexing, time.

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Re: Economic reasons for rate increase by the Fed?

Post by MichCPA » Thu Sep 27, 2018 2:04 pm

The Fed provides liquidity through its loans to banks in order to promote stability in the financial sector. Mis-pricing the interest rates reduces this stability. High interest rates reduce the ability of firms to make new investments on credit and thus restricts growth. Artificially low rates can create debt bubbles, high leverage, and other types of localized inflation. That can raise overall prices and when the asset bubble bursts, the liabilities do not go away.

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Re: Economic reasons for rate increase by the Fed?

Post by alex_686 » Thu Sep 27, 2018 2:23 pm

Phineas J. Whoopee wrote:
Thu Sep 27, 2018 8:16 am
You did not show a misunderstanding of what the Fed did, but just to be clear, especially for others who may come across this thread, the Fed changed the target rate for overnight loans of reserves among banks. The Fed does not control interest rates, plural. The rate it changed the target for is the Federal Funds Rate, which doesn't apply to you and me unless you and I are both licensed commercial banks.
I will take the other side of this argument. While technically true it is functionally false. While it does not affect the rates we pay directly it has substantial indirect power. It effectively sets a floor for short term interest rates. For anybody who has had to build a yield curve, one knows how short term rates can affect long term rates.

I am not saying that they have absolute power, but they are one of the 800 pound gorillas out there.

MichCPA
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Re: Economic reasons for rate increase by the Fed?

Post by MichCPA » Thu Sep 27, 2018 2:35 pm

alex_686 wrote:
Thu Sep 27, 2018 2:23 pm
Phineas J. Whoopee wrote:
Thu Sep 27, 2018 8:16 am
You did not show a misunderstanding of what the Fed did, but just to be clear, especially for others who may come across this thread, the Fed changed the target rate for overnight loans of reserves among banks. The Fed does not control interest rates, plural. The rate it changed the target for is the Federal Funds Rate, which doesn't apply to you and me unless you and I are both licensed commercial banks.
I will take the other side of this argument. While technically true it is functionally false. While it does not affect the rates we pay directly it has substantial indirect power. It effectively sets a floor for short term interest rates. For anybody who has had to build a yield curve, one knows how short term rates can affect long term rates.

I am not saying that they have absolute power, but they are one of the 800 pound gorillas out there.
Its tough to argue that point. If the fed doesn't affect interest rates people pay, why have credit card increases followed fed increases within single digit basis points? On short term, revolving debt, or variable rate debt there is no doubt that fed rates have fairly immediate and direct effects, because the FFR or LIBOR is often a benchmark.

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Re: Economic reasons for rate increase by the Fed?

Post by JBTX » Thu Sep 27, 2018 5:09 pm

Why increase short term interest rates?

- economy is heating up / full employment
- at such low interest rate levels fed has no tools in case of another recession
- overall government and private debt is growing
- starting to see tiny signs of inflation

lotusflower
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Re: Economic reasons for rate increase by the Fed?

Post by lotusflower » Thu Sep 27, 2018 9:06 pm

Boglegrappler wrote:
Thu Sep 27, 2018 12:28 pm
One of the largest reasons for the recent rate increases is that the Fed has only a couple of tools at its disposal. The use of "quantitative easing" in the past years amounts to printing money to buy securities, and that's something that they're not particularly comfortable with.

The Fed much prefers pushing around the short end of the credit market. But with rates where they were two years ago, they are essentially out of ammunition to protect against the next downturn. Getting short rates up off the ground creates some space for them to react to the next recession by lowering rates.

IMO, that is the biggest reason for raising rates currently. Its to recover the utility of one of your basic tools.
Yes. Adjusting Fed Funds Rate is knob that can be turned to adjust the economy (supposedly), or perhaps a gas pedal. If the gas pedal is already touching the floorboards and you need to go faster, there's nothing you can do and the pedal is useless. If you can back off to the middle of the range and things keep working then you can once again choose to press the pedal more or ease up on it to control your speed. This doesn't work in a car because you can't reconfigure your engine while driving, but an economy is a lot more complicated than a car.

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Re: Economic reasons for rate increase by the Fed?

Post by Portfolio7 » Thu Sep 27, 2018 9:50 pm

bottlecap wrote:
Wed Sep 26, 2018 8:40 pm
dm200 wrote:
Wed Sep 26, 2018 6:06 pm
bottlecap wrote:
Wed Sep 26, 2018 4:55 pm
The short answer is because politicians, the Fed, and many economists believe that they can successfully reguate the economy through such measures and eliminate (or "smooth out") booms and busts.
It just doesn't work well in practice.
JT
Others have different opinions and conclusions.
Of course they, and you, do.

But I'd like to take a moment to introduce you to the Great Depression. And the go-go Sixties. And stagflation in the Seventies. 1987. Heck, Japan. The exuberant Nineties. The tech crash of 2000. And the Great Recession.

The opinions may be different, but the conclusion is undeniable. The Fed can’t predict the economy any more than a Boglehead. If it can't do that, it will continue to fall short.

I wish it could. We'd all be eating rainbow stew.

But alas, this is reality.

JT
I'd suggest that instability was greater before the Fed was created, which indicates it has been at least a modest improvement over the lack of a Fed. There have been 5 depressions in US History, 4 of them before the Fed was created, and I would say (not sure of settled opinion) none of them after the Fed started to understand the concept of money supply. However, there is more to the story than the overnight rate.

Managing overnight interest rates is one reasonably powerful tool, but my understanding is that the real purpose of the Fed is to serve as a national clearing house for financial transactions in a crisis. When no bank will trust another bank, the Fed will act as an intermediary, serving as a transaction broker to receive assets from banks to facilitate exchanges and keep markets functioning that would otherwise collapse (which some markets did in a few relatively isolated instances in 2008, but arguably it would have been far worse without the actions of the Fed).
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Re: Economic reasons for rate increase by the Fed?

Post by Oicuryy » Thu Sep 27, 2018 11:41 pm

The economic benefit of the Fed's monetary policy efforts is a stable, predictable value of the dollar.

The value of a dollar, like the value of everything else, is determined by supply and demand. The Fed attempts to keep the supply of money growing slightly faster than demand so that the value of dollars declines about two percent per year.

As discussed in this thread, banks can create money when they make loans. The Fed influences market interest rates in order to influence the demand for loans. That is how they attempt to manage the supply of bank-created money.

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Re: Economic reasons for rate increase by the Fed?

Post by MossySF » Fri Sep 28, 2018 12:41 am

Banks, lenders, investors are already free to set any rate they want.

The Fed rate only applies to inter-bank lending.

Have you noticed the bank savings rates & MMF rates have been going up the past few months even before this Fed announcement? You might say the Fed is just moving their rates following what is already happening in the markets.

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Re: Economic reasons for rate increase by the Fed?

Post by Valuethinker » Fri Sep 28, 2018 3:10 am

Oicuryy wrote:
Thu Sep 27, 2018 11:41 pm
The economic benefit of the Fed's monetary policy efforts is a stable, predictable value of the dollar.

The value of a dollar, like the value of everything else, is determined by supply and demand. The Fed attempts to keep the supply of money growing slightly faster than demand so that the value of dollars declines about two percent per year.

As discussed in this thread, banks can create money when they make loans. The Fed influences market interest rates in order to influence the demand for loans. That is how they attempt to manage the supply of bank-created money.

Ron
The US is something like 1/5th of world GDP (it's less than that now, but certainly in the 1980s it was that or more). The dollar also has the "exorbitant privilege" aka seigneurage of being the international currency of denomination and of reserve. Thus external parties hold dollars rather than exchanging them for their own currencies - estimated benefit to USA c. $50bn pa. That does not mean the Fed can overturn market forces.

Look at the Plaza Agreement (1985) and the move of the dollar up to that point, and down from there.

We live in the age of the "dirty float". I doubt the Fed actually can do much about the level of the dollar.

If we think of the Bank of England and Black Wednesday (September 1992) and the 20% devaluation against the Deutsche Mark that day, then we ca see that even a very powerful Central Bank, with 300 years of history, couldn't stop the currency markets and George Soros (he was merely the most prominent of many).

In some sense a US devaluation is never a "dollar crisis" because of the exorbitant privilege, as above. The US devalues but so many things are priced in dollars and so many parties hold dollars, that it is much less of a net loss in buying power. The same is true for a dollar appreciation.

The Fed has at best crude influence over this, if any at all.

Rather, I think it still works towards its mandate, stable growth of the US economy with limited inflation (but, inflation). The effect of the USD level is considered, but it's not their main policy target.

The exchange rate has an effect on the US economy but it is a small one -- the US economy is relatively closed (autarkic) compared to the other big economies which are much more export driven (Japan, Germany). If you strip out NAFTA*, then the US has a relatively small traded goods sector. Its biggest commodity imports, such as oil, are in fact priced in USD. Even car manufacturers tend to move their assembly and parts supply onshore to the USA or Mexico. Etc.

* less true of Mexico, but I would argue Canada is basically part of the USA from an economic point of view. A USA with state healthcare and its own currency, maybe, but an extension of the USA economically -- a supplier of raw materials like oil and softwood lumber, etc. to American industry and consumers. Mexico's manufacturing industry is a horizontally and vertically integrated supplier to US manufacturers, so the level of integration is very high at that level, the Canadian equivalents would be Quebec's aerospace industry and Ontario's automotive industry -- they are simply extensions of Ohio, say.

Canada in other words is a historical and geographical accident ;-).

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Re: Economic reasons for rate increase by the Fed?

Post by boglerdude » Fri Sep 28, 2018 4:25 am

We could have full employment by paying folks to dig holes and fill them back up, so how and why is the Fed trying to change the employment rate

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Re: Economic reasons for rate increase by the Fed?

Post by JoMoney » Fri Sep 28, 2018 4:42 am

boglerdude wrote:
Fri Sep 28, 2018 4:25 am
We could have full employment by paying folks to dig holes and fill them back up, so how and why is the Fed trying to change the employment rate
I believe the idea is to use monetary levers to influence those who've saved money to invest it in production requiring labor for things the economy actually wants, which can create a virtuous cycle of employees earning money, which they will spend back into the economy. The Fed isn't trying to decide what it is the economy needs, or how to do it, just grease the wheels and keep things flowing. There's only value in digging ditches if someone wants/needs a ditch.
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Re: Economic reasons for rate increase by the Fed?

Post by Valuethinker » Fri Sep 28, 2018 5:01 am

boglerdude wrote:
Fri Sep 28, 2018 4:25 am
We could have full employment by paying folks to dig holes and fill them back up, so how and why is the Fed trying to change the employment rate
I am going to treat this as a real question rather than a meant to be sarcastic comment. This forum is not a twitter tweet.

1. what you describe is fiscal policy - tax and spending by governments. Since the 1970s, countries have more or less abandoned active fiscal policy targetting the unemployment rate. Major exceptions are the 2009 ARRA recovery act (whose effects were mostly finished by mid 2010) and the Chinese government post 2008 (probably the largest building boom in human history).

Cutting taxes as per the current Congress & Administration, is meant to have similar effects as an increase in government spending.

2. It has been understood since at least 1929 that Monetary Policy (interest rates) has an effect on employment. Certain industries like homebuilding are highly sensitive to interest rates but also things like the rate consumers can finance their purchases of durables (cars, appliances etc.) on.

Thus in 1980-81 when interest rates were raised to 21 per cent to control inflation, cyclical parts of the US economy like housebuilding and commercial construction dropped through the floor. Also the long ascent of the US dollar to September 1985 began which squeezed manufacturing - that's where the term "Rust Belt" for the Midwest began (Pittsburgh was once Steel Town; see any track from that period by Bruce Springsteen)

The Fed minds inflation and has a long run target of 2%. Interest rates is its main (often its only) policy lever to increase or slow the economy and thus wage and price increases. Helpfully, if it raises interest rates the USD also rises, which reduces inflationary pressures to an extent.

The costs of up to 12% inflation (at its worst) in the 1970s were very high for the economy as a whole, and the cost of bringing that down was extreme (that early 1980s recession). Thus, the Fed is full of people who have grown up on the "never again" philosophy - that Central Banks will never again lose control of inflation like that.

The US economy currently is as close to full employment as it has been since 1999. Oil prices have shot up to $80 a barrel and given the effort to isolate Iran, may go to $90. These all raise inflationary pressures and the Fed is watching the situation like a hawk. Add to that the stimulus from the tax cut (bigger US govt deficit) and you have the (potential) makings of an inflationary spiral again.

The Fed will do its damn best to avoid that occurring.

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Re: Economic reasons for rate increase by the Fed?

Post by Valuethinker » Fri Sep 28, 2018 5:05 am

JoMoney wrote:
Fri Sep 28, 2018 4:42 am
boglerdude wrote:
Fri Sep 28, 2018 4:25 am
We could have full employment by paying folks to dig holes and fill them back up, so how and why is the Fed trying to change the employment rate
I believe the idea is to use monetary levers to influence those who've saved money to invest it in production requiring labor for things the economy actually wants, which can create a virtuous cycle of employees earning money, which they will spend back into the economy. The Fed isn't trying to decide what it is the economy needs, or how to do it, just grease the wheels and keep things flowing. There's only value in digging ditches if someone wants/needs a ditch.
Thus, ditch digging is a small part of the US economy (fiscal policy, govt spending on infrastructure). The US probably needs more money spent on repairing bridges & roads, but we are not talking anything the scale of, say, building the Interstate Highway System in the 1950s, 60s & 70s (largest civil construction project in history, excepting the recent Chinese one). Say 0.5% additional on non-military infrastructure, p.a. would probably do it, if sustained for 15+ years. The main issue is sustained - you can't fix a mature infrastructure in a hurry.

But healthcare is a huge part-- nearly 20% of GDP. That's where additional spending has tended to go.

Military is historically large but is now relatively small (c. 3.5% of US GDP?). A 20% rise in defence spending is only c. 0.5% of GDP.

I think the tax cut was around 1.5% of GDP however it's hard to structure a tax cut so the money actually gets spent -- that's the traditional problem with tax cuts as a stimulative device.

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Re: Economic reasons for rate increase by the Fed?

Post by onourway » Fri Sep 28, 2018 5:12 am

MossySF wrote:
Fri Sep 28, 2018 12:41 am
Banks, lenders, investors are already free to set any rate they want.

The Fed rate only applies to inter-bank lending.

Have you noticed the bank savings rates & MMF rates have been going up the past few months even before this Fed announcement? You might say the Fed is just moving their rates following what is already happening in the markets.
From my observation, interest rates in these accounts had flattened (in fact they even dropped a basis point or two in mid-August) until the most recent announcement by the Fed, when they again jumped. The increases typically precede the actual announcement by a few weeks because the Fed uses very clear language to signal what they intend to do.

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Re: Economic reasons for rate increase by the Fed?

Post by Valuethinker » Fri Sep 28, 2018 5:25 am

MossySF wrote:
Fri Sep 28, 2018 12:41 am
Banks, lenders, investors are already free to set any rate they want.

The Fed rate only applies to inter-bank lending.

Have you noticed the bank savings rates & MMF rates have been going up the past few months even before this Fed announcement? You might say the Fed is just moving their rates following what is already happening in the markets.
During the Crisis the Fed found that interbank lending rates remained stubbornly high.

They could lower the Fed Funds rate but they couldn't stop the flight-to-safety -- money was just not being lent and that turns the financial system into a plumbing system with no water supply. Various new and creative interventions in the money markets were devised to try to get the system working again - the US Treasury's guarantee of Money Market Funds (a key piece of the Shadow Banking System, which by definition the Fed does not control directly) was probably critical there. Also (see Adam Tooze's latest book) the Fed support for dollar deposits & lending in European banks (the Eurodollar interbank market).

Quantitative Easing was the effort to drive the longer term bond market yields down. All the analyses of QE in the test case countries (US, UK, Eurozone) suggest that the effect becomes more muted over time. One estimate I saw for the UK, where the Bank of England bought c. 1/3rd of all UK government debt outstanding, is that it lowered interest rates by 1-1.5% at most. Significant (current 10 year yield on UK gilt/ govt bond is 1.6%) but not decisive.

The UK had one more policy lever. With a relatively small economy and very open between 3 big currencies (US, Eurozone, Japan) we can devalue-- or rather we could let the currency fall without getting in the market's way.. Which we did, by about 30% on a trade weighted basis. Had we not done that, the impact of the crash would have been far, far worse on the UK economy.

Then the 2010 government's Austerity programme began to bite, at the same time as the Eurozone encountered the Greek Crisis ... it's been a long 10 years, indeed :?

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Re: Economic reasons for rate increase by the Fed?

Post by JoMoney » Fri Sep 28, 2018 5:26 am

Valuethinker wrote:
Fri Sep 28, 2018 5:05 am
JoMoney wrote:
Fri Sep 28, 2018 4:42 am
boglerdude wrote:
Fri Sep 28, 2018 4:25 am
We could have full employment by paying folks to dig holes and fill them back up, so how and why is the Fed trying to change the employment rate
I believe the idea is to use monetary levers to influence those who've saved money to invest it in production requiring labor for things the economy actually wants, which can create a virtuous cycle of employees earning money, which they will spend back into the economy. The Fed isn't trying to decide what it is the economy needs, or how to do it, just grease the wheels and keep things flowing. There's only value in digging ditches if someone wants/needs a ditch.
Thus, ditch digging is a small part of the US economy (fiscal policy, govt spending on infrastructure). The US probably needs more money spent on repairing bridges & roads, but we are not talking anything the scale of, say, building the Interstate Highway System in the 1950s, 60s & 70s (largest civil construction project in history, excepting the recent Chinese one). Say 0.5% additional on non-military infrastructure, p.a. would probably do it, if sustained for 15+ years. The main issue is sustained - you can't fix a mature infrastructure in a hurry.

But healthcare is a huge part-- nearly 20% of GDP. That's where additional spending has tended to go.

Military is historically large but is now relatively small (c. 3.5% of US GDP?). A 20% rise in defence spending is only c. 0.5% of GDP.

I think the tax cut was around 1.5% of GDP however it's hard to structure a tax cut so the money actually gets spent -- that's the traditional problem with tax cuts as a stimulative device.

Even when it is spent, there's the issue of trade deficits. They can stimulate the money to get invested, but if the investment is moving production outside the economy, so does some of the employment benefit. It might help raise up the standards for working classes somewhere, but workers in developed countries aren't keen on competing with workers from less-developed countries for wages and working conditions, and it creates other deficits in the social safety nets funded by workers (i.e. social security, medicare)
"To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks." - Benjamin Graham

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Re: Economic reasons for rate increase by the Fed?

Post by Valuethinker » Fri Sep 28, 2018 5:58 am

JoMoney wrote:
Fri Sep 28, 2018 5:26 am
Valuethinker wrote:
Fri Sep 28, 2018 5:05 am
JoMoney wrote:
Fri Sep 28, 2018 4:42 am
boglerdude wrote:
Fri Sep 28, 2018 4:25 am
We could have full employment by paying folks to dig holes and fill them back up, so how and why is the Fed trying to change the employment rate
I believe the idea is to use monetary levers to influence those who've saved money to invest it in production requiring labor for things the economy actually wants, which can create a virtuous cycle of employees earning money, which they will spend back into the economy. The Fed isn't trying to decide what it is the economy needs, or how to do it, just grease the wheels and keep things flowing. There's only value in digging ditches if someone wants/needs a ditch.
Thus, ditch digging is a small part of the US economy (fiscal policy, govt spending on infrastructure). The US probably needs more money spent on repairing bridges & roads, but we are not talking anything the scale of, say, building the Interstate Highway System in the 1950s, 60s & 70s (largest civil construction project in history, excepting the recent Chinese one). Say 0.5% additional on non-military infrastructure, p.a. would probably do it, if sustained for 15+ years. The main issue is sustained - you can't fix a mature infrastructure in a hurry.

But healthcare is a huge part-- nearly 20% of GDP. That's where additional spending has tended to go.

Military is historically large but is now relatively small (c. 3.5% of US GDP?). A 20% rise in defence spending is only c. 0.5% of GDP.

I think the tax cut was around 1.5% of GDP however it's hard to structure a tax cut so the money actually gets spent -- that's the traditional problem with tax cuts as a stimulative device.

Even when it is spent, there's the issue of trade deficits. They can stimulate the money to get invested, but if the investment is moving production outside the economy, so does some of the employment benefit. It might help raise up the standards for working classes somewhere, but workers in developed countries aren't keen on competing with workers from less-developed countries for wages and working conditions, and it creates other deficits in the social safety nets funded by workers (i.e. social security, medicare)
Yes, but imports are not a huge fraction of the US economy. That's particularly true if you include NAFTA - in the sense that the US imports raw materials and energy from Canada, and Canadian and Mexican manufacturing are fully integrated into US - I saw some estimate that a car part crosses the 2 borders a total of 20 times on the way to being part of a fully assembled car.

If you look at an iphone say, of that $1000 only about $100 is Chinese manufacturing cost. The bulk of its value is actually in the software and Apple's profit margins. In addition the network operator, ap fees to Apple etc.

Say the propensity to consume imports of $1000 in an American ditch digger's pocket is c. $200, say.

That still leaves $800 spent in the USA itself. Healthcare, housing are the big ones for American workers. Education for their kids. In addition there's food -- US is a major food exporter. Even if the workers drive imported cars, most are from transplant factories, these days, I believe. And the finance, the dealer margin & service margins are all in the US economy, not the Japanese or South Korean. The construction machinery may well be from Caterpillar etc.

The US is just too huge an economy, and a relatively insulated one in terms of trade, for this import leakage to be a huge factor.

There are sectors of the US economy that have had their wages lowered by international competition. But manufacturing is not a huge part of the US labour force-- it's been falling in every developed economy. For workers in service industries, like all those people who work in healthcare who shop at WalMart, it's been a blessing. And there are far more service workers than manufacturing workers.

The key to US wages is higher productivity. But it's also noticeable that the US has the greatest disparity between the top paid and the median wage -- that's a social issue, not one of trade policy.

There's actually been reshoring (onshoring) going on due to low US natural gas prices -- for capital intensive (but low employment) industries. And soaring wages in China.

And a narrowly nationalistic view of trade policy doesn't get you too far. The USA imports a lot of raw materials, and is a major oil importer. Are we arguing that the US should stop importing foreign oil, and make do without Canadian syncrude for example? The US is both nearly the world's largest oil producer, and its largest oil importer. There's no way fracking could make that gap up in a hurry, despite its impressive success. The US is actually a gas exporter to Mexico.

Halving oil consumption would require American drivers to double their fuel economy overnight and for Americans to do a lot less flying. And there'd still be issues re truck logistics with fewer goods being moved. Is that a good policy for the American worker?

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Re: Economic reasons for rate increase by the Fed?

Post by Oicuryy » Fri Sep 28, 2018 9:16 am

cj2018 wrote:
Wed Sep 26, 2018 4:48 pm
  • In a free market, shouldn't banks constantly assess market conditions and adjust their lending standards/criteria and consequently rates they can offer to customers in order to stay competitive and win business from borrowers?
They should and they do. Banks freely and independently choose to set their prime lending rate three percentage points higher than the upper limit of the Fed's target range for the federal funds rate.

U.S. banks don't do a lot of borrowing and lending of federal funds these days. (See here.) The federal funds rate is mostly just a signal that banks use as an input to their rate setting process.

Ron
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Re: Economic reasons for rate increase by the Fed?

Post by Phineas J. Whoopee » Fri Sep 28, 2018 12:57 pm

MichCPA wrote:
Thu Sep 27, 2018 2:35 pm
alex_686 wrote:
Thu Sep 27, 2018 2:23 pm
Phineas J. Whoopee wrote:
Thu Sep 27, 2018 8:16 am
You did not show a misunderstanding of what the Fed did, but just to be clear, especially for others who may come across this thread, the Fed changed the target rate for overnight loans of reserves among banks. The Fed does not control interest rates, plural. The rate it changed the target for is the Federal Funds Rate, which doesn't apply to you and me unless you and I are both licensed commercial banks.
I will take the other side of this argument. While technically true it is functionally false. While it does not affect the rates we pay directly it has substantial indirect power. It effectively sets a floor for short term interest rates. For anybody who has had to build a yield curve, one knows how short term rates can affect long term rates.

I am not saying that they have absolute power, but they are one of the 800 pound gorillas out there.
Its tough to argue that point. If the fed doesn't affect interest rates people pay, why have credit card increases followed fed increases within single digit basis points? On short term, revolving debt, or variable rate debt there is no doubt that fed rates have fairly immediate and direct effects, because the FFR or LIBOR is often a benchmark.
Fortunately for me I carefully chose the word control, not influence.

The Fed has far less control than is frequently expressed here at bogleheads.org.

PJW

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Re: Economic reasons for rate increase by the Fed?

Post by boglerdude » Sat Sep 29, 2018 1:40 am

What (real-world consequences) would happen if they stopped paying IOER? It looks like free money for the banks, so why not stop paying it

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Re: Economic reasons for rate increase by the Fed?

Post by jalbert » Sat Sep 29, 2018 2:09 am

I think the extent to which the fed infringes on the free market is a complex matter that is more amenable to debate than resolution.

One major mission of the Fed is to promote price stability. Failing to increase the money supply and lower rates in 2008/2009 likely would have led to deflation and a failure to accomplish this mission. Currently, the Fed is more worried about inflation. Waiting too long to address it likely would mean a more painful process when they ultimately did address it (downturn of 1982-1984 would be an example).

I think the Fed is also concerned about getting to a place of at least somewhat normalized rates so that they have the headroom to fight the next recession.
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Re: Economic reasons for rate increase by the Fed?

Post by alex_686 » Sat Sep 29, 2018 7:38 am

boglerdude wrote:
Sat Sep 29, 2018 1:40 am
What (real-world consequences) would happen if they stopped paying IOER? It looks like free money for the banks, so why not stop paying it
The banks would buy short term Treasuries, which IIRC, also qualify as liquid reserve capital. This kind of happened in 2008 when IOER was significantly lower than short term Treasuries. The amount deposited with the Fed dropped to the minimum.

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Re: Economic reasons for rate increase by the Fed?

Post by Oicuryy » Sat Sep 29, 2018 9:37 am

boglerdude wrote:
Sat Sep 29, 2018 1:40 am
What (real-world consequences) would happen if they stopped paying IOER? It looks like free money for the banks, so why not stop paying it
Higher inflation, maybe.

See this article about who is lending and who is borrowing federal funds.
The Federal Funds Market since the Financial Crisis

IOER gives foreign banks an incentive to borrow federal funds. Without that incentive there would be little or no borrowing. The effective federal funds interest rate would likely fall below the Fed's target range.

Currently banks set their prime rate three percentage points above the upper limit of the Fed's target range for the federal funds rate. Would they still do that if the effective fed funds rate was below the target range? Or would they lower their prime rate?

Lower bank lending rates could encourage more borrowing and spending. That could drive up prices.

Here is another way to think about it. Without interest on excess reserves banks might try to convert their excess reserves into required reserves. To do that they would need to create more deposits. To do that they would need to make more loans. More borrowing could lead to more spending and higher prices.

Ron
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