Changing Interest Rates

Last week I discussed value as it relates to the recent volatility in the stock market. Some commentators have attributed price volatility to recent changes in interest rates. They have gone on to speculate about when the Federal Reserve will “raise interest rates.” I figured now would be a good time to open the subject of why the Federal Reserve — or anyone else — cannot raise interest rates.

The truth of this statement lies in the fact that an interest rate amounts to a dependent variable. No one can change a dependent variable directly. Changing a dependent variable requires changing one or more of the independent variables used to calculate it.

It’s that simple, but I should explain in a bit more detail.

In the details of my explanation I will refer to the diagram below.

First, this diagram shows the number of units of goods on the vertical axis and time on the horizontal axis. The left side of the time axis indicates the amount of current goods provided by one party in exchange. The right side of the time axis indicates the amount of future goods provided by another party in the same exchange.

Second, for the sake of explanation, people divide the future goods into two categories: principal and interest. The principal amounts to the number of units provided as current goods. The interest equals the difference between the total future goods and the amount of principal.

Third, the sloping line between the total current goods and the total future goods represents the rate of change in interest. The slope of that line equals the rate of interest. To be precise, the rate of interest to the quantity of goods exchanged with each unit of time. To state it another way, an interest rate would amount to, for example, five units per year or 10 units per year or, if it were a money transaction, $10 per year.

What people frequently refer to as an interest rate, really consists of a fractional rate of interest. It consists of the rate of change in interest over time as a percent of principal — e.g. five percent per year or 10 percent per year.

Fourth, the only ways in which the rate of interest or the fractional rate of interest can change are to change one or both of: the quantity of current goods or the quantity of future goods.

I have described interest in terms of goods, rather than dollars, because interest can be paid in any good in addition to money. This distinction becomes important when we take into consideration that money simply acts as a medium of indirect exchange.

Thus, the Federal Reserve can only influence rates by engaging in transactions that influence the amount of current dollars available or the amount of future dollars (usually in the form of government bonds) available. Clearly understanding how the Federal Reserve goes about influencing interest rates will help you more clearly understand the impact and limitations of this influence.

I will return to this point in future posts, because more examples will make this very important concept clearer.

Fed Funds Explained

The financial press makes a big deal about whether the Federal Reserve will either leave the fed funds rate where it is, raise it, or get really silly, and drive interest rates below zero. In making these comments, however, they seem to assume that everyone understands the fed funds market and how it operates.

Fed Funds Redux - 16
Fed Funds Market Dynamics

Can the Fed actually control interest rates? And, does the fed funds rate actually have a significant influence on broader market interest rates?

To answer these questions one must first understand what is the fed funds market and how does it operate. To help you gain this understanding I have put together a presentation entitled “Fed Funds Explained.” You can find that presentation at this link: Fed Funds Explained.

Fed Funds Rate; Who Cares?

People who care about financial markets have speculated about the effects of the Fed “raising” the fed funds rate. Would it cause the stock market to decline? Would the economy return to recession? Would mortgage rates start to rise and kill the housing recovery?

A person does not need a plethora of charts and graphs to gain a basic understanding of relationships between fed actions, fed funds rates, financial markets, and economic activity.

First, the Fed does not “set” interest rates in any market, including the fed funds market. Interest rates consist of the ratio of future money to current money. As a ratio— calculated from two independent variables — an interest rate is a dependent variable. It cannot be set or determined directly. One or more of the dependent variables must change in order for an interest rate to change.

Second, participation in the fed funds market is limited to financial institutions that have accounts with the Fed. As a closed market the total number of dollars borrowed equals the total number of dollars lent. Net lending in the fed funds market equals zero. Thus, the level of total excess reserves does not affect rates. It’s the interbank imbalances in reserve accounts that cause fed funds borrowing. So what determines interest rates?

Third, because of the closed nature of the fed funds market, the Fed funds rate is determined by the relative levels of excess reserves between banks in the system. To discover the determinants of fed funds rates, you need to examine the factors that affect those relative excess reserve balances. Those factors can include: Fed open market activities, which either increase or decrease excess reserves in individual banks; the demand for bank funds (i.e. deposit liabilities); or the willingness of banks to create more deposits for the purchase of notes.

Fourth, with a banking system awash in excess reserves, what would cause rates to change? How many securities would the Fed need to sell to have the slightest effect on the fed funds rate? A lot. Simply announcing a rate hike does not change that. The Fed funds rate is zero because banks don’t have a need for reserves. Fed action has not changed that.

I will address, in more detail, questions raised by my comments above in future posts.