by Warning – hard money types are going to lose their minds over this article. I apologize in advance. It’s impossible to talk about interest rates without running into people who think the Fed has “manipulated” interest rates lower than they otherwise would be. As if the bond market has become nothing more than one huge completely manipulated Federal Reserve market. This is a really intuitively appealing argument and it’s not even completely wrong, but I want to add some important operational facts for context. Importantly, I am not here to say that the Fed doesn’t manipulate stuff. In fact, the Fed is an explicit manipulation of the regulatory structure of the overnight settlement market. But I am here to argue that the Fed doesn’t manipulate rates DOWN. In fact, they pretty much always
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Warning – hard money types are going to lose their minds over this article. I apologize in advance.
It’s impossible to talk about interest rates without running into people who think the Fed has “manipulated” interest rates lower than they otherwise would be. As if the bond market has become nothing more than one huge completely manipulated Federal Reserve market. This is a really intuitively appealing argument and it’s not even completely wrong, but I want to add some important operational facts for context. Importantly, I am not here to say that the Fed doesn’t manipulate stuff. In fact, the Fed is an explicit manipulation of the regulatory structure of the overnight settlement market. But I am here to argue that the Fed doesn’t manipulate rates DOWN. In fact, they pretty much always manipulate rates UP. Let me explain.
Before we had the Fed we had private bank clearinghouses. That is, after all, what the Fed really is. They’re a huge payment clearing system where banks use overnight reserves to settle interbank payments. Before the Fed was a thing the overnight settlement process was handled by private banks who would use private interbank clearinghouses to meet at the end of the day and settle their interbank payments. So, JP Morgan and Bank of America would both use the NY Clearinghouse and at the end of the business day they’d meet up and settle up all their interbank payments. The problem was, when the proverbial economic sh*t hit the fan, the JPM guys would go to meet with the B of A guys and they’d say “wait, can we trust your balance sheet because we know you hold a bunch of debt from Terrible Railroad Company Inc and they’re going down…”
This story happened over and over again until a bunch of bad recessions turned into financial panics because the interbank payment systems would close down and exacerbate everything going on in the real economy. This was especially bad because if Great Railroad Company Inc also banked at B of A they might have payments that didn’t settle at JPM because they just so happened to bank at the same bank as Terrible Railroad Company Inc. The whole payment system would seize up just because banks didn’t trust one another over a few bad companies. This is a big reason why there were so many financial panics and depressions in the 1800s and early 1900s. Basically, the economic piping had become so intertwined that everyone’s bathrooms would stop working just because one part of the piping was bad. This was no bueno. Enter the Fed.¹
In 1913 we created a system where we didn’t have to rely on JPM and B of A to trust one another during the really bad times. You had a third party entity that would leverage the powers of the Federal Government to help regulate interbank payment markets. Of course, the trade off was that this entity would always be involved, good times or bad. This whole system was massively vindicated in 2008 when it looked like a financial panic was about to destroy the whole economic system, but the Fed helped avoid a financial panic from turning into a Second Great Depression. People like to complain about what the Fed did in 2008, but the alternative is something none of us want to ever live through. But the key point is that the Federal Reserve is a literal regulatory structure that helps oversee and maintain interbank payments. In other words, it’s a total manipulation of what would otherwise be a private clearing system.
Of course, the kicker is that private banks are really bad at private clearing during panics. Which is not shocking. So this “manipulation” makes sense in the same way that speed limits make sense. We don’t have speed limits because everyone is a bad driver all the time. We have speed limits because some people are bad drivers some of the time and endanger innocent people in the process. But we don’t go around saying “speed limits are manipulated!” No, regulations are reality. In this case, the same basic thing is true of the Fed Funds Market. Regulation is reality. It doesn’t matter how sensitive your feelings are about speed limits or overnight rates. They simply don’t matter to the fact that regulation is reality.
But this is actually more operational in nature. You see, there’s no solvency risk in a reserve deposit because it’s issued by an entity that literally cannot run out of money. So, just like the natural rate of interest on a dollar bill is 0%, so too is the natural rate of interest on a reserve deposit 0%. More importantly, reserves are issued in a closed system to entities that are required to hold a certain quantity of them. They don’t want 0% earning assets. So, when the Fed forces banks to hold these assets the banks try to lend them to one another to make some money on an otherwise useless asset. But since it’s a closed system in an imposed regulatory structure the banks can’t lend them out in aggregate. And this drives the rate back to its natural rate of 0%. So, when the Fed wants to establish some sort of positive rate they ALWAYS have to incentivize banks to hold them. They do this currently by paying interest on reserves. In other words, the Fed does not “manipulate” rates lower. In fact, the Fed’s very existence makes it impossible for them to manipulate rates lower because the natural rate is 0% due to the imposed closed nature of the regulatory system.²
Anyhow, the next time someone tells you that interest rates are manipulated lower you can tell them that the Fed Funds Rate is actually manipulated higher any time it’s not at 0%.
¹ – A lot of people have conspiracy theories about the Fed and its creation. Most of them revolve around the idea that the Fed was a big government power grab. I have my own conspiracy theory though. I basically think the Fed system was a compromise by big bankers who agreed to allow some government intervention in exchange for them continuing to control the monetary system. So, instead of letting the government nationalize the entire banking system and money system, the bankers basically gave up some power in exchange for being allowed to issue loans with government support.
² – You could argue that the “natural rate” on government debt should be something like a real rate. For instance, I actually think the Fed should peg the overnight rate at something like core PCE and just let it automatically reset every month instead of intervening in a discretionary hand wavy way. But this doesn’t change the fact that the nominal natural rate of an overnight reserve is 0%.
NB – Of course, all of this has an important impact on other interest rates in the economy. But the key point is that the main benchmark interest rate has a natural rate of 0% so everything is basically benchmarked off this natural rate.
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