Friday, July 31, 2015

7/31/15 Quote - well said regarding increasing interest rates

Retired economist Scott Grannis:

What the Fed is proposing to do is to lessen the degree of monetary accommodation by a modest amount. That is quite distinct from "hiking" rates in an effort to tighten monetary policy. Although the Fed usually only talks about the nominal overnight rate, what they are really targeting is the real overnight rate, which is currently about -1%. They could raise short term rates to 1% and the real funds rate would only be zero, which is hardly what one might consider "tight." 

Raising the overnight rate from -1% to zero is not really hiking rates or tightening, it is more accurately described—as the Fed says—as "normalizing" interest rates; getting rates back to some semblance of normality.

It is also important to recognize that for many years there will be a huge amount of excess reserves in the banking system. Those reserves could support an almost unlimited amount of lending. Because the Fed can't drain all those excess reserves quickly, they need to raise the interest rate they pay on those reserves to a level which leaves the banking system content to hold lots of excess reserves, and not seek to expand lending dramatically. Banks must see the rate on excess reserves as attractive, on a risk-adjusted basis, relative to the yield they could obtain by making new loans, otherwise bank lending will accelerate and that could lead to an unwanted increase in the supply of money. Which of course would work to push up inflation.

The Fed can well afford to normalize rates in this environment, since there are no signs of stress that would warrant the continued existence of extreme monetary accommodation. The economy is not fragile nor is it hanging by a thread, nor is it in danger of hitting "stall speed." It is simply growing at a slow, and relatively steady rate with lots of unused and idle capacity.

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