When will the Federal Reserve raise interest rates next?
Minutes from its most recent meeting, held July 27 and released Wednesday, suggested officials are still focused on hiking rates this year. Investors believe there’s about a 41% chance that the next rate hike will come in December.
But the question about when the Fed will do the deed misses the point, according to two economists with practical experience working for the central bank.
In a world where too much money is sloshing around in pursuit of scant yield, the Fed’s traditional mechanism for raising interest rates, increasing the short-term federal funds rate, lures capital from across the globe. That foreign purchasing sends bond prices higher and flattens the yield curve, a phenomenon that has traditionally signalled the start of a recession.
So David Berson, chief economist for Nationwide Insurance and formerly a visiting scholar at the Kansas City Fed, and Robert Eisenbeis, chief monetary economist for Cumberland Advisors who spent much of his earlier career at the Atlanta Fed and at the DC-based Board, have a different suggestion.
The Fed should engage in a form of “negative quantitative easing” and allow some of the debt it currently holds on its $4.5 trillion balance sheet to run off when it matures, Eisenbeis and Berson believe.
Federal Reserve balance sheet showing post-financial crisis response
The balance sheet swelled as the Fed purchased Treasurys and mortgage-backed securities once they’d slashed rates near zero in the aftermath of the financial crisis. It has continued to reinvest those bonds as they mature to hold the balance sheet steady.
But if debt matured, it would keep short rates from rising, and especially if the Fed targeted medium- and long-dated maturities to run off, would push rates along the middle and longer end of the curve upward.
“So you get higher rates and less liquidity in the economy overall but at the same time you get a steeper yield curve and for financial institutions, you would improve the net interest margin, which is positive,” Berson said.
The Fed’s traditional influence over interest rates seems to be waning. On December 16, 2015, the day policymakers committed to the first rate hike in nearly a decade, the 10-year Treasury yielded 2.28%. Nine months later, it’s at 1.56%.
Conversely, many economists believe the Fed’s actions in lowering rates to near-zero and holding them there for years has not had the effect policymakers were looking for, either, Eisenbeis noted. “One of the questions that should be on the table, is why with all the excess reserves hasn’t there been more credit extension?”
Now analysts are questioning whether the central bank’s traditional “transmission mechanism,” the federal funds rate, is the best tool for it to use on the way up or down, Berson noted.
It’s entirely possible that policymakers are considering the “negative QE” approach Berson and Eisenbeis favor, but there’s no evidence in official published minutes. “Are they talking about it elsewhere, are the research departments at both the Board and in the regional banks discussing it? Probably. But we don’t know,” Berson said.
Eisenbeis wonders if something else is going on. “One of the things I’m a little bit concerned about is the potential for groupthink in this case, where they may focus in and hone in on one particular sort of approach. I think the example of this is they seem to be really locked into this reverse repo rate.”
The reverse repo rate is a tool that the Fed is deploying in this rate cycle. It sets a threshold underneath short-term interest rates by borrowing money overnight on the reverse repurchase market in exchange for Treasury securities it holds.
No matter what the Fed does with its balance sheet as it continues to “normalize” monetary policy, Berson and Eisenbeis believe the balance sheet will stay higher for longer. (Former Fed chair Ben Bernanke, who guided the central bank’s post-crisis triage, told MarketWatch last December that the size of the balance sheet was “an open question.”)
For whatever it’s worth, both men believe the next rate increase will come in December. The September meeting will be too soon for enough positive data about the economy to have accumulated, Berson said. And Eisenbeis believes the central bank will keep a distance between its decisions and the presidential election.