Saturday, May 22, 2010

What next? Negative Interest?

A couple months ago I saw an analysis that showed the rate of interest targeted by the Fed Open Market Committee had declined over the last twenty years or so. Each cycle showed the targeted interest rate to be lower than the previous cycle. The question posed was, what would happen the next time, and if the economy gets going again, there will be a next time, But the Fed is already at zero. What will they do?

The target interest rate is what we hear called the Federal Funds rate or the Discount Rate. It is the rate the Fed charges banks, members of the Fed, to borrow from the Fed to maintain the minimum level of their deposits (sometimes called reserves) at the Fed. The law that set up the Fed. requires all member banks to maintain deposits (reserves) at the Fed. These funds are not available to the bank to use for any purpose except the Fed’s manipulation. The amount of the deposits that a bank must have with the Fed is a percentage of its demand deposits, called checking accounts by you and me. The Open Market Committee decides what percentage of demand deposits a member bank must have on hand, currently 10%.

If a bank’s deposits falls below 10% at any point, the bank must either deposit funds, borrow from another bank, or borrow from the Fed. And the Fed charges an interest rate, which, as I said, is called the Discount Rate or the Federal Funds rate. This is the interest rate that you hear or read about all the time in the popular press. It is considered a big deal. “Investors” buy or sell on expectations about the rate, banks connect their “Prime Rate” to the Discount Rate, mainstream economists connect their predictions on the economy based upon the Discount Rate, and so on.

The Discount rate is not maintained by decree, actually. It is a market rate, which is why it is called a target. The Fed. maintains the rate by adding or subtracting the amount of money available for bank member borrowing to cover minimum Fed. deposits. Ultimately, this is how the Fed. manipulates the money supply, but adding or subtracting money in the member banks Fed. deposit accounts (see elsewhere in my blog for a detailed explanation).

Therefore, the Fed. lowers the discount rate by adding money to the economy through the banks deposits. Currently, the Fed. Discount Rate is 0.00 to 0.25%, or nothing. The rate has been zero for well over a year. Supposedly, when rates are low, banks will loan more money, and, in current “thinking”, the economy will whiz along. Oh. You noticed no whizzing? What a surprise. Actually, banks have been contracting lending for well over a year, both to businesses and to consumers. Even with a zero percent interest, the Fed. can’t get the economy going. Even with the “stimulus” packages, they can’t get the economy going. What a surprise.

The chart I mentioned at the beginning suggests that future efforts of the Fed. will have a problem. That each successive round of encouragement from the Fed. has required lower interest rates. Well, you can’t get lower than zero. Free money would seem to be the ideal from these people. Hmmmm. The current situation is somewhat confused by the fact that the Fed. is paying interest for the first time ever on the Fed. member bank deposits. Before September, 2008, the way banks made money on expanded Fed. deposits was by taking 90% of the dollars the Fed. had given them in their member deposit account into their bank and loaning those dollars out (theoretically, there was nothing stopping them from just creating new demand deposits in their bank that equaled ten times the new Fed. deposits, but accounting niceties kind of made that difficult). Because the Fed. had created a massive amount of member bank deposits, about $1T vs. the normal $50B, the Fed. wanted to encourage the banks to keep the money at the Fed. so it began paying interest (not much, but more than zero). It turned out that it wasn’t necessary to offer interest, since the banks aren’t lending.

The Fed. keeps talking about the time when the economy begins growing again and it can raise interest rates, absorb all that money it created, and wallow in its self congratulations. But, here we are, a few months from two years of Fed. and BO encouragement, and no recovery. Some slight good news is published and everybody gets excited, and the next week there is new bad news and everyone feels worse. Unemployment figures continue to look bad. Well, I won’t dwell on the sorry picture.

So the chart I mentioned implies that if and when things get going, to the extent they can go at all with the huge burdens the BO has saddled us with, the Fed. is going to have to keep interest rates lower than in the last cycle, which was lower than the cycle before that. Of course, that will mean huge flows of made-up money, both in bank credit expansion and government spending, asset inflation, price inflation (currently 2.4% in the much criticized CPI), and probably very slow, real growth. Then, a couple years down the road the next bust comes (in a shorter cycle, I would think), the Fed. will have nowhere to go. The interest rates for the boom would be very close to zero, say 1-2%, and zero will not do much, probably even less than now. True to his convictions, Bernanke, the Fed. Chairman, will have flooded the country with more made-up money (we need to start calling him “Flood Money” Bernanke), and the next recession will just continue. We can expect more condemnation of capitalism, more destruction of our productive capacity, further crippling regulation of our financial system, a move toward greater violence and despair, and no economic growth or future. At least the cycle of boom and bust might have come to an end.

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