Tuesday, March 28, 2017

Interest Rates, Among Other Things

If you are familiar with interest rates then you'll probably understand everything I am about to say. If you do not, then this may be helpful to understanding them a little further.

The reason I want to try and explain this in a more basic way is because for the longest time I had no idea what people meant or were talking about when they said, "the Fed is going to raise interest rates" and "I wonder if Yellen will increase interest rates during the next meeting." 
Very general questions with answers I did not understand. What did it mean? Now, maybe I was in the minority in that I didn't know, but my economics professor drilled it into my head and I don't think I will ever forget it now. He explained it in a way that was easy to understand and the implications surrounding the decisions were more clear.

The rate that changes is actually the fed funds rate. That is the interest rate charged on bank to bank transfers. Depending on the amount of liquidity required and held by a bank, they may have extra to lend or not enough and need to borrow. The rate that the Fed is changing is this one; bank to bank transfers. One thing to note with this; it is not a hard and fast rate. It is more like a target rate to shoot for. The Fed can lend more or less to try and move the interest rates that banks end up paying.

There is a sweet spot for when banks love the raising of rates. Many Banks have a ton of cash on hand right now. While interest rates have been low and lending was increasing, banks have known that interest rates would rise and they started hoarding cash. With interest rates rising, these banks are earning a larger return on their piles of cash. That is great for the financial industry and it has been rallying. To be honest, I don't know too much about this part, so I will stop talking.

When interest rates are low, it encourages more lending to be done by banks in what is called an expansionary monetary policy. It is called expansionary because the lending done by banks is what increases the money supply. Investopedia has a good explanation. This type of policy is implemented to combat recessions. The grey bars are recessions in this FRED graph of the effective federal funds rate. The evidence here shows that during recessions the interest rates were lowered.

People and businesses worry about their finances the most in dire times and the lower rates encourages companies to borrow money since the rates are lower. If they borrow money, they assume it will go toward growing their business and hiring new people and if enough of this goes on then the economy will start to stabilize and grow again. In the past, the rate started to go back up around 4 or 5 years after the recession had ended. They are just now starting to rise some 8 to 9 years after the crisis in 2008.

The pitfalls that come from an expansionary policy is most notably inflationary risk. The general price level of goods rise and the purchasing power of the dollar decreases. High rates of inflation are bad as the value of the money becomes worthless. Russia had that problem in the early 1990s to the point where people were burning their piles of ruble to stay warm. While inflation is generally bad, deflation is much, much worse.

When there are too many goods or there is not enough money to buy them, that is called deflation. In order to make products more reasonable, they will lower the price of them. To cut costs and try and save their bottom line the company will lay off employees. Now, people are earning less money and can't afford or won't buy the goods the company is producing which hurts there bottom line and forces them to lay off more employees...and it can turn into a vicious circle ending in recession or depression.

We can think about this in terms of outstanding loans. In this example we will use Trevor and Brooke as debt holders. Trevor is impacted by inflation and Brooke by deflation.

     Trevor earns $10/hr and with inflation the value of his income increases to $15/hr. If he owes $60 dollars, instead of working 6 hours for the money, he'll only need to work 4 hours.

     Brooke earns $10/hr too. But with deflation the value of her income decreases to $5/hr. If she also owes $60 dollars, instead of working 6 hours, she will have to work 12 hours to pay it off.

The opposite of expansionary monetary policy is contractionary monetary policy. When the Fed raises interest rates it is usually a sign that the top economic heads in the US believe that the economy is stable enough to cut back on the expansionary policy. They aren't necessarily going contractionary right now, but they are slowing down the expansion. It doesn't have to be one of the other. Each are used in times of need. A contractionary monetary policy was put into place in the late 1970s and early 80s when inflation peaked at 14.3%. By 1983 it had fallen to 3% because of Paul Volcker.

Paul Volcker was the heading the Fed at the time. He was known as a hard nosed, no nonsense guy and wasn't afraid if people didn't like him. He knew know one else would make the changes necessary to drop inflation ad bring the country back to normal and safe levels. To counteract the rising inflation, Volcker jacked up interest rates in bank to bank transfers so they would stop lending and creating money. In 1981, Volcker raised the interest rates to near 20% and like mentioned previously, brought inflation down to 3% in two years. The high interest rates so quickly threw the country into the worst recession the world has seen since The Great Depression. It needed to happen. Inflation was getting out of hand. What Volcker did was a grandiose example of contractionary monetary policy but it paints the picture well. 

*If I made any mistakes please let me know. Leave a comment, tweet at me, anything. I'm not perfect and don't know everything. If I'm wrong I'd appreciate knowing what is right.

No comments:

Post a Comment