What the Fed’s method of raising interest rates reveals about the state of the global economy
Meeting expectations, the Federal Open Market Committee raised short-term interest rates yesterday to 0.25 percent. The first hike in almost a decade ends seven years of zero-interest-rate policy in the United States. Unlike previous hikes, however, this one won’t be done with the usual toolkit. After years of extraordinary monetary policy, the markets the Federal Reserve usually directly intervenes in are so flush with cash that the usual tweaking won’t work. Instead, the central bank will work through two channels: the rate on excess reserves that banks hold at the central bank, and intervening in the overnight repo market.
A lot has changed since the last interest rate hike, including the rise of the shadow banking system—of which the repo market is one aspect. While the changes in the financial markets may seem abstract from the real-world economy, they are, in fact, a reflection of major changes in the global economy.
In a paper from January of this year, economist Zoltan Pozsar of the Institute for New Economic Thinking lays out how the rise of shadow banking is merely the other side of the coin from secular stagnation. In short, secular stagnation is the permanent surplus of savings over investment, and the shadow banking system is where that excess savings gets stashed.
What makes the shadow banking system bank-like is that the savers assume they can withdraw their cash without a loss, just as a depositor at a traditional bank would. The difference, of course, is that shadow banks’ reserves aren’t guaranteed by government institutions like the Federal Deposit Insurance Corporation. The importance of financial institutions that might look like the investment funds but are treated like banks can be seen in the recent concerns about high-yield bond funds.
At the same time, the high amount of savings in the global system also means the Federal Open Market Committee might not have very far to hike. Interest rates over the medium and long term have been on the decline for several decades, and will likely settle at low rates for quite a while. This means, regardless of the pace of increases, the summit at which the Federal Reserve will stop its hiking will be much lower than in the past. That assumes, of course, that the Fed finishes the hike before the start of another recession. The result may be, as Matt O’Brien argues in The Washington Post, that the time away from zero interest rates will be short.
The last time the Fed started a cycle of interest rate hikes, then-Fed chair Alan Greenspan deemed the unresponsiveness of long-term rates to the hikes a “conundrum.” That was a sign of the changing global dynamics in which the central bank operates—and this new cycle may make crystal clear how different things have become. The mechanisms being implemented are a recognition of these changes, even if the ultimate target necessarily isn’t.
While the Federal Reserve is an incredibly powerful economic institution, it is still very much bound by wider conditions of the global economy.
(AP Photo/Jacquelyn Martin)