Gold News

Why the Fed Can't Raise Interest Rates

Even if it wants to...

JUST WHEN a full-blooded rally gets underway, the Federal Reserve comes out and spoils it, writes Greg Canavan for the Daily Reckoning Australia

Yesterday saw the release of the minutes to the Fed's December board meeting. The market was a little disappointed at the lack of complete craziness of the board members. Evidence of considered and rational debate resulted in some selling of stocks. There is a lingering fear amongst the speculator class that the Fed may have some semblance of a plot that they haven't lost yet.

Here's the offending part of the minutes release (with our emphasis):

'In their discussion of the staff presentation, some participants asked about the possible consequences of the alternative purchase programs for the expected path of Federal Reserve remittances to the Treasury Department, and a few indicated the need for additional consideration of the implications of such purchases for the eventual normalization of the stance of monetary policy and the size and composition of the Federal Reserve's balance sheet.'

We highlighted the important bit. It's saying that a few (two?) of the committee members hold the view that additional purchases of treasury debt could make it tough if the Fed ever wants to think about returning to a normal monetary policy.

What is normal, you may ask? It's a pointless question, because in the monetary system we currently operate under you'll never see normal again. To answer the question though, normal means getting rates back above zero, to maybe 1% or 2%.

The fact that some Fed committee members are still operating with such naivety gave cause for concern, and US indexes fell slightly overnight. But we reckon the speculators have these 'few' members well and truly measured for size.

Because from what we understand of how the US monetary system works, raising rates will be an almost impossible task. We recall the Fed discussing normalization of interest rate settings back in early 2010. They did this to ease concerns about the long term inflationary effects of ultra-low interest rates. But it was all just words. The Fed had no intention of doing anything, and if they did, it was in complete ignorance of the enormity of the world's economic problems.

Nearly three years later, and we're hearing the same noises.

So let us explain why we think you'll never see a 2%, 3% or 5% Fed funds rate again...

When the Fed lowers interest rates, it does so by buying assets (usually government bonds) with 'Fed Funds'. The Fed, obviously, is the sole creator of these Fed Funds. The presence of more Fed Funds (which we'll call cash) in the system lowers the cost of obtaining that cash, hence the interest rate, also called the Fed Funds rate, falls.

When monetary policy operates normally, the banking system makes use of these funds so there are no 'excess reserves' in the system. In other words, there is not an excess of Fed Funds. Those banks that hold too much sell them and those that need overnight cash buy them (at the going Fed Funds rate).

But when the interest rate (the Fed funds rate) hits zero, it's an indication that there is enough 'cash' in the banking system, because the price of the cash is near zero. As a result, excess reserves start to grow. That is, there is more than enough reserves, hence the 'excess'.

So what happens when you get to zero interest rates and the system still doesn't respond? You get quantitative easing, which just creates more and more excess reserves. And these reserves remain as 'excess' because there is no demand for credit from the private sector.

For the record, there is now $1.5 trillion in excess reserves held by the US banking system.

I'm guessing that the system carries around such a huge pile of excess reserves because it represents roughly the amount of bad collateral that the Fed has monetized over the years. But we're getting off the point.

Which is, if you want to get anywhere near returning to a normal monetary policy, you'll need to see the Fed SELLING assets, not purchasing them. To get back to 'normal' it would need to sell around $1.5 trillion in assets, thus eliminating the excess reserves from the system and creating a genuine market for Fed Funds again.

We could be wrong here. We're sure Bernanke has some harebrained plan to raise interest rates again without shrinking the balance sheet.

But we'll go on record anyway and bet the Fed won't be able to raise rates ever again...not without causing a major depression.

That's not to say the market won't do it for them. At some point, the market will overwhelm the Fed. It may not be this year or next, but it will happen.

That's not giving you much in the way of investment ideas. Short US bonds? That's a no-brainer...just like shorting Japanese bonds has been for the past decade. So much so that the trade is known as a 'widow-maker'. That's because it kills (as in commercially) all those who try it. So while the logic is compelling, making money is all in the timing.

And that's the hard bit. 

Time to Buy Gold?...

Greg Canavan is editorial director of Fat Tail Investment Research and has been a regular guest on CNBC, ABC and BoardRoomRadio, as well as a contributor to publications as diverse as and the Sydney Morning Herald.

See the full archive of Greg Canavan.

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