Why the Fed CANNOT Raise Interest Rates

Jan 2012

Why the Fed CANNOT Raise Interest Rates

Many think that whether or not the Federal Reserve will raise rates down the line is simply a matter of discretion. Commentators often discuss the “will” of the Fed to focus on inflation and adjust rates accordingly, but what is missed is how the Fed’s hands are actually tied to an inflationary monetary policy for the foreseeable future.

The Fed’s Cost of Funding Cannot be Raised

The Fed, like most banks, pays interest on the reserve holdings which banks store at the central bank. This is the rate the Fed would adjust if they tried to raise interest rates, but doing so also increases the cost the Fed must pay banks for holding those balances. This is not insignificant, because the size of reserve balances held at the Fed is at historically high levels:

If the Fed were to raise rates by just 1%, the cost to the Fed would be $16 billion dollars. Whether this seems like a lot or a little to you, this represents more than 30% of the entire Fed’s capital base. If all remains equal, the Fed will be bankrupt in less than four years given a 1% rate increase. In the same sense, the Fed cannot raise interest rates to even 4%, the amount the Fed views as “normal”, without bankrupting themselves in less than one year.

Keep in mind, the Fed Chairman, Ben Bernanke, favors this tool the most for “exiting” their extreme monetary policy accommodations undertaken during this crisis, yet he never mentions the cost to the Fed for employing this tool:

Bernanke: “In particular, our ability to pay interest on reserve balances held at the Federal Reserve Banks will allow us to put upward pressure on short-term market interest rates and thus to tighten monetary policy when required, even if bank reserves remain high.”

Bernanke: “Even if bank reserves remain high, however, our ability to pay interest on reserve balances will allow us to put upward pressure on short-term market interest rates and thus to tighten monetary policy when required.”

The Fed’s Balance Sheet CANNOT Shrink

Bernanke has often stated that the Fed will return their balance sheet size to pre-crisis levels, which he fails to mention would involve selling more than $2 trillion worth of assets, but given his confidence the lack of realism in such a claim is not immediately obvious. As recently as last year, Bernanke, before congress, claimed that the Fed’s balance sheet would “normalize”:

Bernanke: “We also continue to plan for the eventual exit from unusually accommodative monetary policies and the normalization of the Federal Reserve’s balance sheet. We have all the tools we need to achieve a smooth and effective exit at the appropriate time.”

The big factor missed in Bernanke’s proposal is again the effect on the Fed’s solvency. The Fed is currently the largest holder of mortgage backed securities (MBS), treasuries, and agency debt, and for them to abandon their post would not leave much demand for them to offload onto. The Fed also holds these assets on their books at prices that they were willing to pay for them with inflationary demand, and do not reflect the real liquidation value. In all, its almost certain the Fed would suffer capital losses if they had to unload massive quantities of these assets, particularly if they do so at a time when nominal price inflation is creeping up which negatively impacts the prices of bonds.

The major issue for the Fed is the fact they are more leveraged than even the worst banks before their bankruptcies, including Lehman Brothers and MF Global. The Fed is leveraged 54 to 1 on their portfolio, meaning losses on their assets are magnified 54 times against their capital. A 2% loss on their asset portfolio would again bankrupt the Fed, and this is true even if the Fed does not unload assets, but just suffers asset mark downs. Because of these restraints, the Fed will not only not be selling assets, but will be forced to keep buying, to effectively cap the prices of the securities they hold so they never suffer nominal losses.

What this Means for Gold and Inflation

Given that the Fed’s hand is forced and that they cannot raise interest rates, or shrink their balance sheet, the Fed is empty of measures to restrain inflation. Raising reserve requirements may be their only choice but the use of this tool would cripple the banking system which is too leveraged to sustain any meaningfully higher reserve ratio. Inflation, therefore, cannot be contained, and the Fed will likely be forced to exacerbate inflationary pressures just to avoid turning insolvent.

Since gold is a major benefactor of an inflationary environment, especially when the Fed is this impaired, prices for precious metals are bound to continue their march forward. The sustained negative interest rates by the Fed will further secure gold’s role as a wealth preservation mechanism as far as the eye can see.

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This entry was posted on Thursday, January 26th, 2012 at 12:12 pm and is filed under Central Bank News, Precious Metals News, Uncategorized. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.