Federal Reserve: Rising Rates Raise Two Key Questions

Fed Chair Powell confirmed the market’s expectations of a 4% Fed Funds rate with more to come. The news launched the usual negative media reports, and a short-lived stock market decline.

So, now what?

To answer that question, we need to understand why the Fed’s rate raising is a positive step forward.

After years of earning next to nothing on their short-term savings and investments, savers, investors, funds and organizations are finally receiving meaningful interest income. Granted it still isn’t enough to offset inflation’s purchasing power erosion, but a “real” (inflation-adjusted) rate is coming. That is, so long as the Fed keeps allowing interest rates to rise.

“Why do you say ‘allowing’?”

Many (most?) people have forgotten that the key job of setting the price of money (interest rates) is the capital (money) market – not the Federal Reserve. Through the extensive, ongoing bidding and offering process, agreed-upon interest rates are determined.

Here’s why that process is superior to the Federal Reserve’s: (Underlining identifies main points)

Especially important are the key benefits:

• First, both buyers and sellers provide or receive a fair (equitable) interest rate at the time the transaction is made.
• Second, capital resources are allocated to the highest/best use (versus abnormally low rate money being used for second-rate or selfish actions).
• Third, rates are set continually during market hours, not at an “interest rate event” that happens only a few times during the year

In rare times of financial stress, when the capital (money) market is unable to fully function, the Federal Reserve can act to restore the market. The serious conditions in 2008 were such a time, so the Federal Reserve stepped in and pushed rates down to a historically low level of near-0%.

However, when conditions improved in 2009 and thereafter, Fed Chair Ben Bernanke decided not to allow the capital market to set short-term interest rates. Instead, near-0% became his base rate, rationalized by his view that the economy was not good enough. This approach eventually became viewed as normal, engendering the belief that it is the Fed’s job to set interest rates.

The damage that the 14-year, abnormally low, Fed-determined interest rate did to savers, investors, funds and organizations is financially and equitably enormous – and it cannot be undone. Moreover, there is a lost sense and understanding that successful capitalism requires a robust capital (money) market to set interest rates. Ironically, the Fed’s own multi-year messaging now hampers its rate-raising. The actions are viewed negatively – as a harmful tightening that will lead to a recession.

The only route to make things “right” again is for the Federal Reserve to stop holding rates down and allow the fully capable capital (money) market to fully operate and reestablish the long-missing market interest rate. Hopefully, that is where this Fed is headed.

The question that no one asks

Since the capital (money) market is fully capable of setting the market interest rate, why doesn’t the Fed simply step away?

“Well, the interest rate could shoot up.”

Yes, the capital (money) market rate would be higher than 4%. But that fact simply means the Fed is continuing to hold down the rate, keeping it below its appropriate level. And that means the Fed continues to run an easy money environment, with its actions not yet producing a true tightening. Therefore, instead of producing a recession, its rate raising is ridding the financial system of abnormally low rates that produce weak and selfish actions.

Moreover, the Fed isn’t protecting us from an untethered, runaway interest rate. In the capital (money) market, all participants can alter their bids and asks, plus jump in and pull out. The market is where all these forces coalesce, ensuring an understandable, fulsome interest rate level in real time.

Another point to remember is that the Fed’s new 4% interest rate 4% is far above last year’s near-0%. So, while today’s capital (money) market rate would be higher, there is less distance to travel now. How far remains? We won’t know that until the capital (money) market is fully operating. At that point, the rate will depend on what terms investors (capital suppliers) and borrowers (capital users) are jointly willing to accept.

To summarize – Yes, the capital (money) market interest rate level is higher than today’s Fed-set 4%. But know that the market rate will be appropriate – that is, fair, equitable, understandable and accepted by the market participants. The same cannot be true for the Federal Reserve’s 12-person decision making process.

The bottom line – The Federal Reserve’s role is to support the capital market, not replace it

Capitalism makes the U.S. economy strong – not Federal Reserve-ism. The long-held view of the Fed’s role in the capital (money) market is as the “lender of last resort,” to ensure the U.S. financial system doesn’t freeze or break. As in 2008, when conditions got out of hand and stressed the capital (money) market, the Fed can step in to provide support and restore confidence. But, then the Fed’s role is to exit and let capitalism get its fully functioning capital markets back again.