ECB and US Fed – Into Uncharted Waters

As the US Federal Reserve contemplates increasing interest rates for the first time since 2006, the ECB is working on a plan on taking its interest rate deeper into negative territory.  In both cases the tools being used are not conventional, the practice is new and based on theory, and the outcomes are predicted, not known due to past experience.  If ever there was a definition of uncharted monetary waters, this is it.  And what a time to be gambling.

To be fair the US Federal Reserve does not set interest rates directly.  Before the crisis the Federal Reserve managed two levers that effectively drove interest rates.  First it mandated and managed the reserve limits banks should maintain with the Fed as “cover” for their loans to help pretoct against runs on the bank.  Any additional money above this minimum was deemed “excess reserves” and would attract interest.  At the same time the Fed offered a rate for short term borrowing to banks; this was used periodically by banks when their own funds were short, or if there was a short term imbalance between banks.  This “inter bank rate” was used in what became known as the federal funds market, and the rate fluctuated based on demand – as supply was unlimited with the Fed being the printer of money.  

Since the crisis however the Federal Reserve balance sheet has ballooned through the QE program.  Its balance sheet has gone from $900 billion in 2006 to $4.5 trillion today.  See Journal of Economic Perspectives, Rewriting Montary Policy 101: What’s the Fed’s Preferred Post-Crisis Approach to Raising Interest Rates, Ihrig, Meade and Weinbach, 2015.  The reserve requirements on what banks need to maintain have grown substantially since the crisis, and so the clearing point for supply and demand has moved significantly but the Fed does not plan sell those assets that comprise part of the challenge.  It plans, according to the paper, to start increasing interest rates on the excess reserve balances with the Fed.  This should encourage, so the theory goes, banks to use their excess reserves in more risk taking adventures such as loans to business – that is assuming businesses are looking for loans (which they are not).  

As the excess reserve rate rises the difference with the public rate will increase and through arbitrage, the gap will or should close.  What this means is that you could borrow money at one rate and re-use (re-loan) it at another, and make a profit.  To reduce this, the public or market interest rate will follow quite closely the interest rate on excess reserves.  No one knows if this will work – it’s never been done before.
At the same time the ECB is talking of more QE and further increasing their negative interest rates.  In this case, as reported in today’s US print edition of the Wall Stree Journal (see Divergent Paths Set for Fed and ECB), they are hoping that such negative interest rates will not be passed onto the high street and more public uses of interest rates.  So far, the negative interest rates used by the ECB, and other countrieslike  Denmark and Switzerland, have not been passed on to consumers.  If they were to be, then citizens would be penalized for saving.  And of course saving is one key enabler for the natural recycling of  money to investments.  Again, as with the US experiment, no one knows if this will happen since the ECB is making it up as they go along.

The problem is not the rates: the problem is with money.  The huge amount of money sloshing around in the system overall has distorted how businesses operate.  We just dont know what will happen in the next phase of the cycle.  In saving the global economy we have created a new monster we dont know how tame.  Isn’t it fun to be an economist at this time?


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