The Federal Reserve and Interest rate increases in 2016

Since 2008, it has been very hard to find a bank that pays any interest on savings accounts. This state of affairs can be blamed on Federal Reserve monetary policy, which  kept short term interest rates close to zero for seven years. After talking about raising interest rates throughout most of 2015, the Federal Open Market Committee finally raised the target level for the Federal funds rate by ¼ point on December 16. Many now expect the Federal Reserve to gradually raise interest rates so that by the end of 2016 the federal funds rate is close to 2 percent.

If the federal funds rate continues to rise, other interest rates will likely follow. Rising interest rates are good for those of us who have money to save, but will discourage people from borrowing money to invest, which is important for economic growth. Higher interest rates in the US also cause the foreign exchange value of the dollar to rise. Given the fragile state of the world economy, this could hasten the coming of a recession to the United States.

Some economists have criticized the Federal Reserve for its quantitative easing, the policy of buying government bonds and mortgage backed securities, which expanded the monetary base by more than five-fold between 2008 and 2014.  Quantitative easing played a major role in holding down interest rates during that time period. It does not follow, however, that the Federal Reserve can improve the economy by now pursuing policy that would raise interest rates toward levels that commonly prevailed before the financial crisis of 2008. Interest rates are low today, not because of current Federal Reserve monetary policy, but because most of the nations of the world are on the brink of a recession.

All interest rates are market determined. Interest rates depend on the supply and demand for loanable funds, which the Federal Reserve alters by buying and selling US government securities or mortgage backed securities. By expanding the monetary base, the Federal Reserve put downward pressure on interest rates. In the past year however, the Federal Reserve has not increased the monetary base. A stable monetary base and money supply should keep inflation rates close to zero, which is a good thing for anyone who is trying to save money.

The federal funds rate, which is the rate banks charge for lending reserves to each other, has been largely irrelevant since 2008, because almost all banks have excess reserves and thus do not need to borrow from banks. Nevertheless, it does move with changes in the interest rate the Federal Reserve pays on excess reserves. Since banks must decide how much of their reserve balances to lend, the rate paid on excess reserves will have an effect on the interest rates banks charge for business and consumer loans.

To further increase the federal funds rate in 2016, the Federal Reserve would have to pay a correspondingly higher interest rate on excess reserves, which would likely discourage banks from lending money. For example, to raise the Federal funds rate to 1 percent, they would need to double the rate they pay on excess reserves, and their interest costs would more than double if banks increased their excess reserves in response to the higher interest rate. Holding more excess reserves is a less risky way for banks to earn interest than lending the money to a business or buying Treasury bills.

Most other central banks, including the European Central Bank, the Bank of Japan and the Chinese central bank have been increasing the supply of their currencies. This is why the dollar has been rising relative to the value of other currencies and the inflation rate in the US has been close to zero. As long as the Federal Reserve continues its policy of maintaining a stable monetary base, inflation should remain low. With recession looming in many parts of the world and many leading indicators pointing to a recession in the US, no good reason exists for the Federal Reserve to further raise interest rates. The Federal Reserve wants to prevent a recession and has indicated that it would like to see the rate of inflation increase so it is closer to the stated target of 2 percent per year.

Since little or no benefit can come to the Federal Reserve from raising the federal funds rate further, and the costs are substantial both in terms of increased likelihood of recession and reduced net income to return to the Treasury, do not be surprised if the federal funds rate remains stable or even falls in 2016. Although this means Americans will not earn much on their savings accounts, the Fed will at least be doing its part to delay the onset of the next recession.