Rate Hikes and the FED

[I just read an article on www.Silver-Phoenix500.com, by Ellen Brown, talking about the FED’s latest Rate Hike Cyle. I was going to add a comment to her post, but there is just so much wrong with what she says, that a simple comment won’t do. -Bob]

   By Bob Shapiro

Ellen Brown discusses the FED’s current Rate Hike Cycle, giving reasons why it’s a bad idea. She says that higher rates will draw foreign money into the US and strengthen the Dollar, which will hurt US exports and increase imports. That indeed may be the case, but only because foreign Central Banks’ policies keep their interest rates near zero percent.

To the extent that stiffer competition and higher borrowing costs will hurt US businesses, then yes, US GDP will suffer. Considering that the FED has kept rates FAR under Free Market rates, creating bubbles in stocks and other areas of the US Economy, a market crash together with a Recession/Depression should not be unexpected outcomes.

Brown goes on to suggest that higher rates and a contracting Economy will cost the Republicans dearly in November 2018, and that also is a reasonable prediction.

Alas, after that, Brown’s logic and understanding get very cloudy. She wonders why the FED, seeing a slowing Economy ahead, would go ahead and raise rates, but she misses the obvious. The FED is a Keynesian organization, which makes them Democrats. A market and Economic crash while the Republicans are in charge will favor the Democrats at election time.

She says that interest paid by Uncle Sam and by corporations will triple in short order. But she just doesn’t get borrowing. When you borrow to buy a house using a fixed rate mortgage, if rates go up in the Economy, do you pay more? Of course not! The US and corporations’ borrowings mostly are long term using bonds of various durations.

Yes, rates will go up when you roll over your debt (or borrow more), but that very real problem doesn’t happen today – it creeps in over time. Now, to the extent that the borrowing was to fund spending that only made sense with zero interest rates, that rolled-over increase in debt due to bad decision making will clear away the incompetent leaders in business and will force government spending cuts. It could be very painful, but the pruning needs to be done occasionally.

Brown doesn’t want the adjustment process ever to be done, so she wants the FED to keep doing what it did (low interest rates). Even more, she wants the FED to monetize the entire federal debt (that the FED doesn’t already own).

She says that the new money, created out of thin air, will get into the banks and will be deposited by the banks as excess reserves – and that these excess reserves cannot be lent out by the banks. Her ignorance is staggering!

So, let’s review the concept of bank reserves. The FED says that banks MUST keep some of its deposits in ‘reserve,’ for use in regular day to day business and in case depositors (as a whole group) want to withdraw an unusually large amount from the bank. The ‘Required Reserves’ are not required on all bank deposits – far from it – but for the sake of this discussion, let’s assume that Brown at least has this right.

The Required Reserves are not available to lend out because… they are required. However, a bank may deposit more than the required reserve amount with the FED. The deposit amount over the required amount is called ‘Excess Reserves.’ While Excess Reserves indeed are available for the bank to lend out (contrary to what Brown thinks), the FED has been discouraging this extra lending by paying the banks about 1% to keep the Excess Reserves on deposit at the FED.

With the FED’s, and the government’s, policies keeping GDP in the toilet for a decade, banks have a limited demand for creditworthy, likely profitable loans, so banks have left a lot of Excess Reserves (in addition to their Required Reserves) on deposit with the FED, earning that 1% return. This is what the FED has referred to as sanitizing all the paper money it’s been creating to buy that ton of Treasuries.

If interest rates are raised by the FED, banks can be expected to start loaning out those Trillions of Excess Reserves. With the Fractional Reserve Banking system that the US has, those Trillions of Excess Reserves could turn into Tens of Trillions of new loans. That would cause much higher CPI increases than even the BLS statistics manipulators would be able to hide. Possibly to the point of Hyperinflation.

Brown wants the FED to create even more money out of thin air and to use it to buy up the rest of the National Debt – over $15 Trillion more! As it gets lent out (contrary to what Brown believes) that’s $150 Trillion in loans, and that definitely gets our country into Hyperinflation.

But, that’s unless the FED can prevent all that money from being lent out. While Brown’s way is nonsense, the FED does have the tool, and we’ve mentioned it already – the Required Reserve regulation. The FED could buy Treasuries and raise the percentage that banks are required to keep on hand. Instead of a 10%, it could become 10.1%, 10.2%, and growing with Treasury purchases to control lending.

A side benefit is that, the FED needn’t pay interest on Required Reserves. If the US pays an average 2% on all its debt to the FED, and then gets it all back, that’s $200 Billion savings on the current $20 Trillion National Debt.

I don’t recommend that we do this, but it is an interesting mental exercise.

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