International Forecaster Weekly

What the Fed Rate Hike Really Means

The real significance of the raid is that it breaks the supposed "independence" of the Fed, by which it can claim that “The Federal Reserve is an independent agency...

James Corbett | December 19, 2015

So unless you've been living on Mars this week you'll no doubt have heard that the Federal Reserve just raised their federal funds rate target, exactly as expected. But what does this even mean, and how it will impact markets in America and around the world?

Let's peel back some of the financial gobbledygook to understand what is actually happening and what is likely to result from this week's move.

1. The Fed did not just raise interest rates
    It's important to understand that the headline that you've seen a million times this week, "Fed raises interest rates," is, technically speaking, a lie.

    Firstly, the interest rate that the Fed is targeting is not one that people will be paying on their car or home loans. Specifically this has to do with the federal funds rate, or the rate at which banks and credit unions with reserves at the Fed lend those reserves to each other in the overnight market. Since the actual rate (known as the "effective federal funds rate") is just the average of all of the rates that individual banks agree to lend/borrow from each other, it varies all the time, and the Fed targets a specific rate (or in this case a range of 0.25% - 0.5%) and tries to keep it there. Yes, this influences the rate at which you'll be able to get a business or personal loan, but the effect is indirect. This means banks can jack up their prime lending rates and "forget" to increase deposit rates.

    Secondly, and most importantly, the Fed does not "set" the federal funds rate directly. It sets a target for that rate and then tries to influence the actual rate to line up with that target. In times past, this has meant that the Fed engages in open market operations in order to pump money into the system (buying securities from banks with Fed funny money conjured out of nothing) or suck money out of the system (selling securities and taking the proceeds out of circulation). When reserves are expanding, money is "cheap" and banks will lend to each other at lower rates, and when the monetary base is contracting it has the opposite effect.

    Why is this important? Because...

2. The Fed cannot use open market operation to influence rates this time around

    Since the global financial meltdown, the Fed has engaged in three rounds of quantitative easing, using Fed funny money to buy trillions of dollars of toxic assets from the banks in the hope that it would encourage banks to start lending again, thus keeping the economy moving. (Spoiler: It didn't work.) This caused the Fed's balance sheet to balloon from $800 billion, where it had been for many years, to $4.5 trillion today.

    But a large chunk of the money that the Fed created to pay for these toxic assets (the mortgage-backed securities and other poisonous garbage that caused the meltdown in the first place) ended up parked at the Fed itself. The banks simply took the money and held most of it as reserves.

    And this created a problem for the Fed in trying to set a federal funds rate target. Whereas before the tiny excess reserves held by banks meant that new Fed money being injected into or sucked out of the system had a big impact, now banks are drowning in reserves and the federal funds rate was falling toward zero.


Also in this issue:

The Biggest threat to the US
Open Immigration
Surveillance bill
Needing a Second Passport
History of Inflation
Weekly Market Numbers
Long & Short List
Nuclear Reactor in Europe
A new Bitcoin
Google & Congress
Importance of Rest