The Federal Reserve controls the US monetary stock through three mechanisms, that is, it has three ways in which it can create money out of thin air:
1) The Fed can directly inject money into the system.
It can do this either by lending money directly to the banks, or by lending the money to the government by purchasing T-bills. More recently, with Quantitative Easing, the Fed has gotten into the habit of printing billions of dollars every week to buy not just T-Bills but private assets like mortgages. We will discuss this direct form of injecting money in the next article.
2) The Fed can indirectly increase the money supply by adjusting the margin requirements.
All commercial banks operate under a fractional reserve banking system whereby they must legally hold a set amount of cash reserves against the amount they lend out to their customers. By adjusting the reserve ratio limits, the Federal Reserve can affect the amount of money commercial banks are able to lend. Currently, the ratio stands at 10%; that is, banks can lend $90 out for every $10 it has on deposit. Most Western central banks don’t need to adjust the margin requirements, as they are set already very low.
3) The Fed can adjust the funds rate.
When private banks issue new loans, they essentially create money out of thin air. By raising and lowering the fed funds rate, the Fed can influence the amount of new loans created. By decreasing interest rates and effectively making money less expensive to borrow, the Federal Reserve increases the demand for money. Conversely, the Federal Reserve can lower the demand for money by targeting a higher interest rate, as Paul Volcker did early in his tenure as Federal Reserve Chairman from August 6, 1979 to August 11, 1987. At present, the effective federal fund rate is being targeted to remain between 0 – 0.25%, the lowest in its history in response to the current financial crisis.
Note: When the Fed cuts interest rates, it affects interest rates across the board, causing rates for bank savings, CDs, commercial bonds, and T-bills to drop as well.
In order to see the Fed’s long-term policy pertaining to interest rates, one has to look at the big picture, the historical trend of interest rates from 1954 to present (December 2009):
As you can see from the 1954 to 1981 (27 years) there was a long trend upwards in interest rates that happened during the best times of U.S. economy. In this early period, one can see that interest rates had moved up to an all time high of 20 percent in 1981. Let’s put this into context. In autumn 1979, U.S. inflation hit a 32-year high of 13 percent, despite double digit interest rates. Inflation was provoked by OPEC’s oil spikes, Vietnam war, Lyndon Johnson’s fiscal expansion to stimulate the Great Society, and the Fed’s excessive pump-priming under the government friendly Chairman Arthur Burns. In October the Federal Reserve under the new leadership of Paul Volcker began a monetary austerity program, implementing even more aggressive rake hikes combined with cutbacks on direct monetary injections, in order to contract the money supply and bring down inflation. The strategy worked to fight inflation and boost the dollar. Investors began to seek out the high-yielding dollar as a way to offset double-digit inflation, causing the dollar index to jump up 50 percent in the first half of the 1980s (reaching a brief high of 160 we will never see again!), and inflation was more than halved in 1982.
However, from 1981 to 2010, that is, the last 29 year period, interest rates have been steadily declining, falling to near zero in 2009. There have been a few brief periods of rate hikes, but in total, there have been more frequent and dramatic rate cuts. In fact, the most recent rapid drop in interest rates occurred post June 2007, at the start of the banking crisis, dropping from 5.26 (July 2007) all the way down to 0.11 (Jan 2010). Currently, it has had a bit of a combeback, but it still sits pretty low at 0.19 (Nov 2010).
You can visualize this recent rapid descent in interest rates here:
Why is it that from 1981 to present, the Fed rates have been dropping down and down to the almost nothing we have today?
The recent economic crisis of 2007-2010 accelerated the fall, but it had been falling for years prior to that. I would argue that the currently low interest rate is the end result of a long term expansionist monetary policy. A monetary policy is considered expansionist when it favors the expansion of the money supply (though direction injections and lower interest rates) as a way to stimulate the economy and/or protect it from economic shocks and downturns.
But when the Fed has been systematically cutting rates and flooding the economy with money and credit for the past 29 years, this behavior has reshaped the US Economy into one big credit bubble, drowning its citizens in government and public debt, with the floodtides of this debt seriously eroding the value of the US dollar.
Wall Street friendly Fed: Greenspan and Bernanke
If Paul Volker was known as the Fed chief of austerity, Greenspan and his successor, Bernanke, are the Fed chiefs of an ultra-loose monterery policy. Since August 11, 1987, with the Alan Greenspan sworn in as Federal Reserve chairman, the historical (and current Fed policy) is to keep fed funds rates as low as possible.
Greenspan made many powerful and rich friends in government and Wall Street, and he was committed to keeping them happy. They wanted him to add fed fuel to the economy and insure it from any corrections and recessions. Greenspan proved he could be their man from the beginning to the end of his 18 year reign.
Shortly after taking office, Greenspan met with a couple major challenges: the stock market correction of October of 1987 and recession of the early 1990s brought about by the collapse of the S&L industry. Greenspan’s response to the 1990s recession was a dramatic cutting of rates, cutting it down 36 percent by July 1991, to 5.75 (from 9% in May 1989), and from there cutting it another 44 percent, reaching a low of 3 percent in September 1992, and keeping it at this low for more than a year.
The dramatic rate cutting strategy in the face of an impending recession became Greenspan’s signature insurance to Wall Street: in 2001-2002, in order to deal with the downturn caused by the internet bubble, he aggressively cut rates to a 45 year low of 1.75 percent by 2001 year end, 1.25 percent by 2002.
And in 2007-2009, in order to deal with the aftermath of the housing bubble, his successor Bernanke followed Greenspan’s path with an aggressive rate cutting campaign that took the funds rate to a 53 year low of 0.11 by Jan 2010.
What is interesting to note in the last two cases of the Fed’s intervention to “save” the economy is that its “cure” for the exploding bubbles is the cause of their forming in the first place. The low interest rate policy of the early 1990s caused the rates for bank savings, CDs, commercial bonds, and T-bills to drop as well, which in term forced the baby boomers and pension funds to take their money out of the declining yields of these safer investments and into the rising yields of the stock market. By 1994 the stock market was already overvalued and becoming a bubble, but Greenspan decided to keep interest rates locked in at 5.75% for the next 5 years, and he expanded the money supply by about $1.6 trillion, or roughly 20 percent of GDP, flooding the economy with money at the time when the stock market was exploding.
The internet stock market became very crazy, with IPOs trading at 100 times sales, and Greenspan became a cheerleader for this new craziness,
adding his own spin to it, reimaging that the economy had entered into a new era in which all the rules were being rewritten:
This was pure crap. At another point he tries to explain away the growing gap between stock prices and actual productivity by arguing that we have reached a stage in history where physical value of the company could be overcome by the inherent value of its ideas. Greenspan’s endorsement of the “new era” paradigm encouraged all the economic craziness of the tech bubble.
Moreover, Greenspan created the psychological insurance for Wall Street’s craziness, the insurance that the Fed would come to the rescue if anything went bad. Once wall street noticed that the Fed was coming to the rescue after the 1987 stock market crash, the Gulf War, the Mexican crisis, the Asian crisis, the LTCM crisis, Y2K, and pumping liquidity into the market to avert further deterioration, there began to emerge an idea called the “Greenspan Put” — referring to the Fed’s pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices. Investors increasingly believed that in a crisis or downturn, the Fed would step in and inject liquidity until the problem got better. Invariably, the Fed did so each time, and the perception became firmly embedded, with the put privatizing profits and socializing losses.
Matt Taibbi in Griftopia accurately details how Greenspan’s characteristic response to the collapse of the tech bubble paved the way for the housing bubble:
Mr. Taibbi goes on to note that Greenspan’s deregulation of the financial markets helped the greedy wall street banks to engineer crafty schemes to make themselves richer:
The amount of new lending was mind-boggling: between 2003 and 2005, outstanding mortgage debt in America grew by $3.7 trillion, which was roughly equal to the entire value of all American real estate in the year 1990 ($3.8 trillion). In other words, American’s in just two years had borrowed the equivalent of two hundred year’s worth of savings.
The low interest rates allow the banks to push endless supplies of easy credit (debt) to people lured into gambling this debt money into ponzi-bubble schemes (overpriced stocks, commodities, and homes) run by the casinos that have become Wall Street. Low interest rates not only provide jet fuel for taking out bigger stakes on higher risk investments, it provides incentive: it pushes people out of the losing yields of traditional nest egg investments (such as bank savings rates, CDs, and bonds – which all lose their yield because of lower fed rates), and lures them into the rising yields of riskier investments like increasingly overpriced stocks, homes, and commodities that are wrapped up in the Wall Street lies that these asset prices and yields can soar upwards indefinitely without risk.
When the former Fed chairmen Alan Greenspan came out saying that this recent financial crisis is “by far” the worst in history, the irony was that he himself was the so-called financial genius who plunged the world into recession, according to a poll of mostly economists, called the Dynamite Prize in Economics. The collapse of the real estate market in 2007-2008 would wipe out roughly 40 percent of the world’s wealth.
Mr. Taibbi adds up the losses caused by Greenspan:
America’s international debt is somewhere in the region of $115 trillion with our debt now well over 50 percent of GDP. This debt is on a level never before seen in a modernized country. It sounds facile to pin this all on one guy, but Greenspan was the crucial enabler of the bad ideas and greed of others. He blew up one bubble and then, when the first one burst, he printed money to inflate the next one. That was the difference between the tech and the housing disasters. In the tech bubble, America lost its own savings. In the housing bubble, we borrowed the shirts we ended up losing, leaving us in a hole twice as deep.
And the pattern repeats itself over again in 2007-2008: with the collapse of the real estate market comes the “bailout” of the Fed (now under Bernake): drastic rate cuts of 500-basis points down to near zero. In early 2008, the financial press had begun discussing the Bernanke Put as the new Federal Reserve Board chairman, Ben Bernanke, continued the practice of reducing interest rates to fight market falls, and for the next two years he kept on the put, keeping interest rates in the 0.00-0.25% range.
Since this turned out to be a worldwide crisis, most central banks dramatically lowered their interest rates in a concerted rate cut in an effort to jump start their own banking sectors teetering on the brink of financial ruin. In addition to the lowering of interest rates, the U.S. had to lend, spend or guarantee $11.6 trillion to bolster financial markets , according to data compiled by Bloomberg News. That included agreeing to backstop exotic shadow obligations such as asset-backed commercial paper, collateralized debt obligations and money market funds that helped finance home mortgages, credit card borrowing, and auto loans.
Note: With that type of money, we could have bought off every mortgage and bought a house for every American who does not have one.
What effect has the Fed’s 27-year low interest rate policy had on the US Dollar?
Since 1985 the U.S. Dollar Index has steadily fallen from 160 all the way down to 80 today, or 50%, corresponding in the big picture terms to the descent of interest rates. That is because the rule holds that falling rates signify damage for the home currency. Lower rates means that more money can be easily loaned out by banks, which in turn greatly increases the money supply and deflates the dollar.
There was a brief period in US dollar history, from 1999-2001, when the dollar became king. The dollar rose off its 1995 low of 80 to reach 120 by the end of 2001, which was a powerful 50% gain in 5 short years. What was the reason for this? This is because all the world was starting to turn its greedy eyes at the dizzying heights of the US stock market, chasing the bull market: net foreign purchases of U.S stocks soared to a record $107.5 billion in 1999, a 53% increase from the 1998 total, and net foreign purchases of stocks rose 39% to a new record of $174.9 billion in 2000. By 2001 the tech bubble was bursting, and the Fed ended up moving to the rescue, dramatically lowering Fed funds rates to 45 year low of 1.75 by year-end. However, the rate cuts were insufficient in preventing 21 percent and 13 percent declines in the Dow and S&P500 for the year.
The rate cuts did not hurt the US dollar as it climbed to its highest point in 10 years to 120 in 2001, but they did hurt the dollar over the next several years. Between 2002-2008, the US dollar enters a bear market that ends up losing 30% of its value under the anti-dollar currency policy of the Bush administration and Greenspan. From 2001 to 2006, under Greenspan’s frantic rate cutting and printing of trillions of new dollars after the collapse of the tech boom, the dollar would lose 24 percent of its value. It would go on to lose an additional 10 percent more by 2008. Yet Greenspan insisted at the end of this period that the devaluation of the dollar was not a problem – so long as you didn’t travel abroad!
I like Taibi’s humorous take on this:
Actions speak louder than words, and the Fed actions in the last 3 decades indicate that their unstated objective has to been to bolster the economy at the expense of the Dollar.
Ben Bernanke is following the same flightpath as Greenspan in respect to the dollar: driving it down. I don’t think he is too much worried over how the effect of near zero interest rate levels and the explosion of fed money is going to have on the US dollar. The idea behind Bernanke’s low interest rate policy has been to jump-start the economy with more debt-orgy, akin to getting us to drink ourselves sober (dejevu 2001-2002: after the fall of tech bubble, Greenspan lowered interest rates to near zero). We have yet to see a full ignition of the debt orgy taking place, because banks are not lending out as much as the Fed wants them to, but they will, given time. These low rates and subsequent increased debt will have its effect in another as yet unseen bubble (the large bubble of which is the Credit Bubble). The US dollar will become hit again and suffer another dramatic fall.
There are already signs that the dollar is breaking against other currencies and commodities. Since 2009, the dollar has fallen considerably against the Yen, Swiss Franc, Aussie, and Canadian dollar. It has not fallen as much against the Euro and Pound due to their own debt issues. The USD/JPY and USD/CHF sit at historical lows, and AUD/USD sits at historic highs. Both gold and silver are at historic highs. These are all very troubling signs for the US Dollar.
Where does interest rates move from here?
There are only two possibilities where interest rates can move from here: 1) Since interest rates cannot move down below zero, they might gradually move back upwards; or 2) interest rates can remain at zero levels for decades.
Contrarian Possibility #1 A few contrarian-minded futures and options advisors have been making a strong case for betting on Fed Funds Futures and Options contracts: pointing to the 50 year chart of the Fed Funds rate, they argue that this bottom of 0.16 (give or take a few basis points) carries the possibility of appreciating 30 times (or 3000%) if the Fed Fund Rate moves from 0.16 back up to 5.00. They see this financial crisis as a tremendous opportunity for profit, trading rates up from near zero. Who knows, they might be right, it might very well be a golden opportunity. Interest rates cannot go down further from the near zero level of today.
However, there is always Possibility #2, that rates might remain at zero levels or very low levels for decades. Japan is an example of the same where interest rates have been below 1% for more then a decade already.
Japan had faced its own deflationary depression a decade ago, and it also tried to fight it by lowering interest rates to near zero. Could our experience become a repeat of Japan?
Some argue that the United States is not following the way of Japan and that interest rates will bounce from near zero than stay that way for long. The reason given is that when Japan had a major asset bubble bust and sequent recession, the country had significant trade surplus, unlike the United States, which is running one of the largest trade deficits.
The logic is as follows: Because United States is running high deficits, they have needed China and Japan to be the largest buyers of U.S. Treasury in order to fund the deficit. However, if the currently low yielding 30-year Treasury bond and 10-year Treasury bond cannot fight current inflation levels, there would be little incentive to buy U.S bonds, and this would act as the market’s demand for higher interest rates. The market’s demand for higher yields would force the Fed to raise interest rates. Because Japan was running trade surpluses it didn’t have to worry about low interest rates for a long period as it did not need to borrow from other countries.
I would counter to this that China and Japan might continue to be big buyers of US Treasury, despite the low rates offered, and that the slack will be bought up by the Fed. The Fed does not mind buying up more and more US Treasuries, and they don’t think Americans mind that much either, for it is like an invisible tax on them, a tax on the purchasing power of the US Dollar. So long as the average Joe American does not travel abroad, so thinks the Fed, he might not notice the destruction of his dollar.
It is very difficult to predict the short term direction and timing of the interest rates. If one could then he would be a mega-millionaire.
That being, said, there is some reason to think that the 29 year long term direction of low interests is still part of the Fed flight path for the future. There might be always some future rate hikes for whatever reasons, but they will never be dramatic so long as the GDP is hobbling at less than 3% growth. Currently it stands at 2.6%. In fact, so long as GDP growth stays less than 3%, we should see a continuation of low rates.
As we have seen, the Fed is still in bed with Wall Street, and that means that the primary concern for the Fed is expand the money supply in order to resserect GDP growth rate and keep the stock market hobbling upwards. After the S&L crisis of the early 1990s, Greenspan kept interest rates low in order to redirect capital from safe investments to the riskier investments of the stock market, and after the tech crisis of 2001, he cut rates to near zero in order to get people to borrow capital to risk in the housing market. He created one bubble (tech bubble) and “saved” us from the full impact of its bursting with the creation of another bubble (housing bubble). Now Ben Bernanke is following suite. In 2008-2009, he has cut interest rates to near zero, and bought up trillions of dollars in toxic mortgage backed securities, in order to desperately “save” us from the full impact of the bursting housing bubble. But the ill-effects cannot so easily be swept under the rug. These “remedies” are ultimately the cause of the disease in the first place, and when they keep being used, the disease (the credit problem) becomes malignant. Inflation will rise, and the US dollar will fall.
While some contrarians think that that it may be safe to bet up from zero, the situation is that rates can stay near zero for a long time to come, flooding more debt money into the economy than ever before. The end result is that inflation will creep upwards, as it has already, with real inflation numbers reported by http://www.shadowstats.com suggesting 8% for 2010, and the US Dollar will continue to deteriorate, as it has already, with Yen, Swiss Franc, and Aussie dollar showing record gains against the dollar.