They say that the road to hell is paved with good intentions – good things that we will get to tomorrow. Take the Federal Reserve for instance: They are going to raise rates – when your target is set at zero, it is tough to do anything else – but when? It could be on Thursday or they could do it later. The market is currently obsessed with this question. Frankly I think we worry far too much about the Fed, but this current episode does shed light on an all too human tendency.
How did we get here? It has been nine years since the Fed last raised rates. In June of 2006 they increased the Fed Funds rate by 0.25 percent to 5.25 percent. It is now at zero, and if one likes to wallow in hyperbole, then this potential 0.25 percent increase is earth shattering. The rate was lowered, bit by bit, during the financial crisis until it hit zero in December of 2008. It has been at zero ever since.
So, what is all this about? The Fed Funds rate is the overnight interest rate that banks must pay other banks to borrow reserves. Banks are required to hold reserves at the Fed based on their deposits. As deposits fluctuate daily, so do reserve requirements. Some banks will have excess reserves and other will need more, so those with excess lend to those that need to borrow. The lower the rate, the more incentive banks with excess reserves have to take those reserves back and do something more constructive, like loan money to you. The Fed raises and lowers this rate in an attempt to discourage or encourage more lending and therefore more economic activity.
During the financial crisis the Fed, rightly in my opinion, needed to act decisively to encourage economic activity. That is always the easy part. There are basically two economic theories as to how the government can help stimulate the economy: Followers of Keynesbelieve in what we call fiscal policy, which is stimulation by running deficits, either through increased spending, lowered taxes or both. The other school is monetarism, most notably represented by Milton Friedman. Monetarists believe in the power of the Fed.
The problem with both academic theories is that they rely on something called normalization: After the crisis du jour has passed, policy makers are supposed to go back to “normal.” In fact, if things start going too well then they are supposed to go beyond normal and run surpluses in fiscal policy and raise interest rates in the case of monetary policy. This is where they both fail.
These institutions are made up of people after all, and most of us suffer from this same ailment. We like to put off unpleasant tasks and indulge in instant gratification. We slowly lose control of our waist line as we convince ourselves that we will start working out tomorrow, and that bowl of ice cream tonight will be easy to burn off. We make a budget, then fudge this month saying that we will just cut our budget next month so we can do whatever fun thing presented itself today. Of course the same thing happens next month and before one knows it he is neck-deep in debt.
Policy makers find it easy to come to the rescue – it’s like spending money while eating ice cream. But, the morning comes and we are supposed to get out of bed and go for a run, and pack our lunch to pinch some pennies. It’s tough. The Fed is supposed to raise rates. We do these things because we know we will crave ice cream again; we will want to take that quick trip. The Fed knows that another recession will happen. If it begins with interest rates already at zero then how can they help? It has to act now.
The move will likely be small and likely a non-event. The question is, have they waited too long? Only time will tell…but I really need to get back in the gym.
Chuck Osborne, CFA