Rising Rates, QE, or Both?

The Federal Open Market Committee (FOMC) wrapped up its latest meeting on Thursday with its much-anticipated announcement. The Federal Reserve will keep its target rate between 0% and 0.25%, as it has been for nearly seven years.

While the FOMC meets about once every month and a half, this latest monetary policy statement was somewhat unique. It was rare in the fact that we really didn’t know what would be announced.

It was a near 50/50 split on whether the Fed would finally raise its key interest rate. If you asked anyone in the financial world two months ago, it was a near certainty that the Fed would raise the federal funds rate in September. But with stock market turmoil, trouble in China, and a continued strong dollar, the prospects for a rate hike dimmed.

The FOMC voted nine to one in favor of leaving the rate near zero. The only dissenting vote, Jeffrey Lacker, preferred a hike of 25 basis points. Now we will have to wait and see if the Fed follows through with a rate hike at all in 2015. It may be determined by the stock market.

Janet Yellen held a press conference after the statement release. She said that the situation abroad bears close watching, somewhat confirming that the Fed is watching the situation in China. Since when is the Fed supposed to determine U.S. monetary policy based on a foreign economy?

Yellen also cited the strengthening dollar and the low price inflation numbers as support for the decision to leave the target interest rate untouched. As a typical Keynesian, Yellen thinks that our money has to depreciate by at least 2% per year.

Perhaps the most curious thing said by Yellen in her press conference is that Congress should be careful about endangering the progress made in the economy. She was referring to suggestions of a government shutdown over the budget. Since when does the Fed chair get involved in recommendations for Congress on spending proposals?

After the announcement on interest rates, the initial reaction from stock investors was not dramatic either way. While you would think that a policy of continued low interest rates would be a signal to buy, there is concern among some investors that the Fed’s unwillingness to raise its target rate by even a small percentage shows its lack of faith in the so-called recovery.

The Overdramatization of the Rate

This latest meeting was a big deal to the financial press. For anyone interested in the economy and the financial markets, it was hard not to pay close attention to what the Fed would do.

However, it is important to step back and look at what the federal funds rate means.

The federal funds rate is a target rate. The Fed tries to get the rate as close to its objective as it can, but it can’t keep it at an exact number. For the last seven years, the Fed has targeted a range of 0% to 0.25% instead of just one number.

We talk about the Fed raising rates or lowering rates, but it is really just this one key rate that the Fed directly controls. It may affect market interest rates, but it doesn’t necessarily have to.

The federal funds rate is the overnight borrowing rate for banks. If a bank needs to borrow money overnight to meet reserve requirements, then it will borrow at this rate.

Since the beginning of the first round of quantitative easing (QE) in 2008, the Fed has created over $3 trillion out of thin air. But about $2.5 trillion of this new money went into excess reserves at the commercial banks. Since the banks don’t need to borrow overnight to meet reserve requirements, the overnight rate has stayed near zero.

The only realistic way for the Fed to raise the federal funds rate is to increase the interest rate paid to banks for their reserves. The Fed has been paying the banks 0.25% on reserves, and it would increase this rate to raise the federal funds rate.

This is the only feasible way for the Fed to raise its target rate because it is not going to sell off trillions of dollars in assets anytime soon.

This is a major break from the past. Prior to 2008, when everything about monetary policy changed, the Fed would control the federal funds rate through the money supply. Generally speaking, if the Fed wanted to raise the overnight bank rate, it would sell off some of its assets to deflate the money supply. If it wanted to lower the federal funds rate, it would buy government debt with money created out of thin air.

In other words, in the past, the federal funds rate was directly tied to the money supply. Lower interest rates and monetary inflation went hand in hand. Higher interest rates and a tighter monetary policy went hand in hand.

Since 2008 and the build-up of huge bank reserves, the federal funds rate has stayed near zero regardless of what the Fed is doing with the money supply.

In this sense, the federal funds rate is not as meaningful as it once was because the Fed can inflate or deflate the money supply with no effect on its target rate.

A Coming Contradiction?

This leads us to a possibility that has not been discussed in the financial press. Is it possible that we could end up getting a hike in the federal funds rate and a new round of QE at the same time?

This sounds like a complete contradiction. And a decade ago, it would have been. It probably wouldn’t have been possible.

But we live in unprecedented times. What if the Fed is like a magician waving his wand with one hand while quietly doing his trick with the other? The hand waving the wand is the interest rate. The other hand is QE.

If the Fed eventually hikes its target rate, then what will this really mean? It means the banks get more free money. It may or may not mean higher market interest rates. The market has known about a possible hike for a year now, and it hasn’t been damaging to bond and Treasury prices. Market interest rates have bounced around a bit but generally have not gone up.

Meanwhile, what if U.S. stocks take another 10% hit over the next few months? Or what if it is worse than that? Is the Fed going to do nothing?

We shouldn’t discount the possibility of the Fed hiking its target rate by increasing the rate it pays on bank reserves, while at the same time starting another round of digital money printing.

The Fed will wave its wand around in the air and pronounce its tightening by raising rates. Meanwhile, its other hand will be quietly buying up more government debt by creating money out of thin air on a computer screen.

While none of this is a certainty, we should be aware of the tricks that the Fed may play, especially given the situation of the economy. If the economy looks to be weakening and price inflation stays low by the Fed’s standards, then what would stop Yellen and company from starting another round of QE?

Implications?

While this can all be a bit confusing (which the Fed prefers), we just have to keep our eyes on both hands of the magician. If the Fed does start another round of QE, then we take that into consideration for our portfolios.

A new round of money creation, assuming it is significant enough, would likely be bullish for commodities and hard assets. Gold would certainly be a beneficiary, and oil might even start looking attractive again.

And while a lot of people are not looking favorably on bonds due to the prospect of higher interest rates, we must differentiate between the Fed’s target rate and actual market interest rates.

Even if the Fed does end up raising the federal funds rate in the near future, this does not automatically translate into higher market interest rates. In fact, if the economy goes into a downturn and stocks go down more, then investors will be seeking safety.

Whether you agree with this or not, U.S. bonds are considered a safe haven, especially in a time when price inflation expectations are low. Some investors look to lock in fixed rates. The yields on long-term bonds could easily go down further in an economic downturn, even if the Fed is “raising rates.”

These are confusing and uncertain times. We really are in uncharted waters. Our main goal right now should be wealth preservation. But there are always opportunities for profit out there. We just have to keep our eyes on both hands of the magician.

Until next time,

Geoffrey Pike for Wealth Daily