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Episode 5 - The Committee, Part II

Intro

Welcome to the Bankster podcast, my name is Alexander Bagehot and I’ll be your host today. This is Episode 5 - The Committee, Part II. If you didn’t get a chance to listen to Episode 3 - The Committee, Part I, I highly recommend going back and listening to it first. You’ll gain a lot more from this episode if you have the background from Episode 3.  Every episode I dive into the intricate world of central banking! I use one or two pieces of news from the Federal Reserve or monetary policy from around the world to summarize, translate, and explain a few points from the Centralverse. The Centralverse being the deep, the fascinating, the ever changing, and the incredibly consequential world of central bankers and the economies they attempt to support.

As you listen you’ll become more and more versed in Centralverse language/lingo/and history. Then, as the summer barbeques start happening in cul de sacs and on apartment decks across the world, and your neighbor brings up the stock market, you’ll have a solid foundation upon which to steer the conversation towards by far the most important institution in the financial world - The Federal Reserve. The news section provides the vocabulary and the contextual understanding of how central banks work. In each episode I also dive deeper into a historical event or person that helped shape what central banking is today. It’s the combination of understanding both the current scene and historical perspective that provides for true comprehension. On this episode we will continue the discussion on the the Federal Open Market Committee (known as the FOMC). Then we will learn about one of the largest figures (both physically and historically) in Federal Reserve History and what he did with interest rates to stabilize the American economy.

 

Interest Rates

 

First, listen to a few titles of articles in the news over just the past week. “A Battle Brews Over Negative Rates on Mortgages”, “US Stocks Drop on Expectations for Higher Interest Rates”, and “New York Fed Chief Believes the Central Bank is on the Right Track”. This list could go on and on. And the theme tying all of these articles together is interest rates. They are constantly talked about in the news. They affect families’ savings and retirement accounts as well as their monthly mortgage and other debt payments. But on a grander scale they affect the way businesses and banks operate. And it’s in the world of banks that the Fed operates their control over the direction of interest rates. Before we discuss how they do this, let’s first make one important clarification. The FOMC does not tell banks what to set as the interest rate for your home mortgage or for a specific business loan that the bank might want to make to a manufacturing company. That’s why there are thousands of banks and all of them are able to compete with one another setting slightly different rates and offering slightly different products. There are almost as many different interest rates as there are loans.

It would be unreasonable and incredibly inefficient for a single, centralized committee to try and set the terms for all of those varying loans. So why do we say that the FOMC controls interest rates? I’ll give two points to demonstrate why this is indeed accurate.  

Point one, all interest rates are interrelated. If John ran a bank and could borrow $1M at 2%, then afterwards he might be willing to loan that money to Sam at 3%. In that case, John could pay back the 2%, take in 3%, and profit the 1% difference. That difference is called the spread. Now if John could only get $1M at 5%, then he wouldn’t be willing to loan the money to Sam at 3%. He wouldn’t accept anything less than 5%.

Banks are constantly making these calculations. It goes back to that fundamental business principle, “Buy Low, Sell High”. Or in bankers terms, “Borrow money at low interest rates, and sell money at high interest rates.” That’s why interest rates are constantly fluctuating. When one lender makes an adjustment to rates it has a ripple effect through other interest rates. Based on this new rate the borrower is limited on the rate he or she can now turn around and lend the money at. Just like we saw in our example with Sam and John. That’s how different interest rates are related.

Point two, the FOMC, the committee from the Federal Reserve, does control one very important interest rate. Follow with me as I give a simplified example of how they do this. Imagine that all of the interest rates are wooden blocks, and they are piled in a very high stack. One block says 7% Car Loan, another says 4% 30-year mortgage, another says 1% checking account, and yet another says 6% student loan. There are thousands of blocks in the stack, and the stack is arranged from lowest to highest, with the low interest rates at the bottom of the stack and the high interest rates at the top. Of this entire stack of varying interest rates between different banks, companies, and individuals, the FOMC controls only one, and that’s the big block at the very bottom - the lowest rate. This block is called the Federal Funds Rate. So what is this rate?

Well, it is has a few key characteristics: (a) The parties involved with these rates are very large banks, (b) The scale of the loans offered at this rate are exceptionally large - often well over $100M, and finally (c) the loans are super short term - literally overnight . So, for example, one bank says to another bank (this is not the beginning of a joke, although it’s sounds like a great intro), I need $120M. The other bank responds ok, I’ll loan you $120M for tonight and then you can pay it back to me tomorrow for a tiny tiny bit of interest. That’s what’s happening on the Federal Funds Market every single day to the sum of hundreds of millions of dollars. The interest rate is tiny, but a tiny bit of interest on a sum of money that large adds up. The rate at which these banks are loaning money back and forth overnight is called, the Fed Funds Rate. We’ll talk about why banks would make or accept these loans in a moment.

But first back to our example of the stack of blocks. Because the Federal Funds Rate is at the bottom of the large stack, when they raise the rate, all of the other blocks get pushed up. When the FOMC decides to lower the rate, all of the other blocks come down as well. That is why it’s often said, that the Federal Reserve controls interest rates. Although a better way to phrase this might be, “The Federal Reserve controls the ‘direction’ of interest rates.” They are moving that bottom interest rate up or down and all of the rates above it, negotiated and controlled by banks and corporations around the world adjust accordingly up or down. It takes months before the effects of a change in the Federal Fund Rate can be seen in the economy. This is one of the challenges that all central banks must grapple with. They have to make decisions that will affect the economy in the future based solely on current and historical information alone.

“But wait?” You may be asking yourself. “In this Federal Funds Market where big, short term loans are made between very large banks, you’ve made no mention of what the FOMC actually does? Do they simply tell banks what the conditions of the loans in this market must be?” These are good questions, and to the latter, no. The Fed doesn’t simply set the rates and force banks to lend to each other at that rate. I’ll take the next few minutes to describe both how the FOMC has controlled the direction of interest rates historically, and then how they control the direction now, post Financial Panic and Great Recession of 2007.

In both cases, it is critical to understand two principles: (Principle 1) interest rates are simply a measure of how expensive money is (or if you remember from Episode 3, it’s the price you pay to spend someone else’s money now, and then pay them back later) and (Principle 2) if you change the supply of money, you can change how expensive money is. Combining these two principles together we see that the FOMC could control the interest rate in the market where Federal Funds are bought and sold by changing the amount of money in the market. This is a unique role that central banks play in the economy - they control the supply of money, or how much money is out there. They can increase the amount of money or decrease the amount of money in the economy as they see fit. This is all done on computers. The money they create comes from simply changing the digits in the digital accounts that banks have at the Federal Reserve. Changing interest rates has nothing to do with the amount of paper money you and I use to buy our candy bars.

When the FOMC decides to increase the amount of money in the Federal Funds market, interest rates go down. When they decrease the amount of money in this market, interest rates go up. The traditional way in which they increased the supply of money was through trading United States Government Treasury securities (which are government bonds or government debt). So how does this work. Well, imagine that you are a bank and you hold a government bond. That’s not money, right? Well, if I am the Federal Reserve and I want to increase the supply of money and thereby lower the interest rate, I can buy that bond from you. I give you money; you give me the bond. That effectively removes the government bond from the economy and puts money into the economy. And if the Federal Reserve wants to do the opposite and increase interest rates, they can sell bonds to banks. By doing this they put bonds into the economy and take money out.

Now, where does this money come from that the Federal Reserve uses to buy the government bond? Well, the Fed creates it out of thin air. Another unique characteristic of central banks, and the foundation upon which they are able to operate.

Let’s walk through an example from start to finish of how the Fed might raise interest rates. Which by the way they very well may do at the next meeting of the FOMC coming up in the middle of June. If they decide to raise the interest rates, this is a breakdown of how it will happen: the FOMC will meet in Washington DC over two days, on the first day they will hear updates about the economy from around the country and around the world. They will also hear from each of the governors based in DC and the 12 Federal Reserve Bank Presidents from around the country. Then on day two the chairwoman, Janet Yellen, will propose an interest rate policy (raise them, lower them, or keep them the same) and the voting members of the committee (head back to Episode 3 if you’ve forgotten how the voting structure works) will vote in favor or against.

Let’s say after discussing the economy that Yellen proposes that they raise interest rates. If the majority of the FOMC votes with her (and in the 80 year history of the FOMC the chairperson has never been outvoted) then they will direct the Federal Reserve Bank of New York to use Open Market Operations to raise the Federal Funds Rate. The following day the traders at the Federal Reserve Bank of New York will sell bonds to the banks in the market. When the banks turn over their money to the Fed it virtually disappears and instead the banks hold bonds. This shrinks the quantity of money in the market and causes the price of money (which remember is interest rates) to rise. And voila, the process of changing interest rates across the economy has begun.

It starts with these few large banks that are trading in the Federal Funds Market and then slowly spreads to other banks, and works its way into business loans and then finally consumer loans. And eventually changes the direction of the economy. If interest rates are high, then companies won’t be as willing to take out loans to expand their business. If businesses don’t take out loans, then they will not expand as rapidly. This causes the economy to slow down. A slowdown in the economy might be good if there is inflation, or even a threat of inflation.

Now, this is the way in which the Fed operated before the financial crisis, and the basic principles still apply today. However, raising rates this time around was a little bit trickier due to one point I haven’t mentioned yet - Why are big banks making such large loans to each other on such short terms? Well, again, this is due directly to the Federal Reserve. The law says that banks have to hold on reserve a certain percentage of their deposits. For example, if you deposit $100 into your checking account, the bank must hold onto about $10 and they can lend the remaining $90. Those $10 can either be kept at the vault at the bank or they can be deposited in the bank’s account at the Federal Reserve.

But imagine that you are a big bank (we’ll call you Bank A). At three in the afternoon you get a phone call from Apple asking to take out a $500M loan to finance the production of their latest iPhone. No big bank is going to pass on an opportunity to make a loan like that, so by four o’clock the loan is made and the bank wires Apple the $500M. This loan was a great deal for the bank but it leaves them way under on the reserve requirement. At the same time, maybe across the country, Bank B gets a notice that Ford just made a deposit of $400M because they sold a lot of the latest electric car. Now Bank B is way over on their reserve requirement. This is where the need for a market place is created. Bank A goes out on the Federal Funds Market, needing money to satisfy their reserve requirement. Bank B also goes to the Fed Funds Market looking to make a few extra dollars on all of their extra reserves. A deal is made and Bank A satisfies their requirement and Bank B earns a tiny bit of interest from the loan.

So the Fed Funds Market is basically just a place where big banks can go to get large, short term loans. They are trading money back and forth. And the Federal Reserve is controlling how much money is in this market place, which in turn controls what the interest rate is on the loans created in the market.

So what happened after the Financial Crisis? Well, the Federal Reserve lowered interest rates really low. In fact they lowered them as far as they traditionally could - to zero. In order to lower interest rates this low they had to put a lot of money into the Fed Funds Market. This served its purpose. Interest rates fell and fell until they hit just north of zero. But then there was a slight problem. All of the banks had lots and lots of extra reserves, so there was no longer any need for them to go to the Federal Funds Market and buy and sell. Remember that most of the reserves are held at the bank's accounts at the Federal Reserve.

One thing that changed in 2008 due to the Crisis was the Federal Reserve was now allowed to pay interest on the reserves that the banks were holding at the Fed. This allows the Federal Reserve to indirectly control how much money is in the Market. But instead of actually putting money into the market by purchasing bonds or taking money out by selling bonds, the Fed now does it indirectly by providing interest on bank’s reserves.

They can change the supply of money by encouraging banks to sit on money. They do this by paying them interest. On the other side they can encourage banks to put their money out in the economy by not paying very much (or even zero) interest.

In summary, the FOMC controls the direction of interest rates across the economy and across the world by controlling just one very important, very low interest rate. This in turn affects when and how many businesses take out new loans and expand, which in turn affects how many jobs are created or lost in the economy.

It’s this responsibility to keep economies from overheating and boosting economies when they are dragging that makes central banks so important. If economies overheat, then inflation quickly takes over and what you used to be able to buy with $5 quickly costs you $10. If economies slow down too much, then businesses stop investing in new products or expanding and then people lose their job.

I’ll now use an example from the tenure of a previous Chairman of the FOMC Paul Volcker to describe how he used the control of the direction of interest rates that the Federal Reserve has to help settle an economy that was spiraling out of control.

An Inflationary Dragon

Standing at 6ft 7in tall, Paul Volcker was a powerful man in a very powerful position. Over the past two episodes we’ve discussed some of the intricacies and inner workings of the FOMC. Well, during a critical time in the United State’s history, Paul Volcker served as the chairman of this committee that is controlling the direction of interest rates in the economy.

The 1970’s had been a rough decade for the United States. The President resigned. There were two recessions. The country ended a long, bloody, and ultimately unsuccessful war in Vietnam. But for our purposes today, the 70’s were rough because of extended, high inflation. There are multiple ways of measuring inflation and we don’t have time to go over each of them today. But on the transcript of today’s episode that will be posted on my website, www.thebanksterpodcast.com you can see an awesome and very readable chart that shows four different measures of inflation in the United States going back to 1950. However, one thing is very clear, whichever measure you look at - there was a dramatic rise in inflation during the 1970’s. High inflationary times are very dangerous for the economy. This is easy to see with a quick double-sided example.

Side one, from the consumer’s perspective. If you knew that your money was going to lose half its value tomorrow, or if what costs $10 dollars today will cost $20 tomorrow, what would you do? Personally, I would go out and spend it today or the moment I get paid. From the other side, imagine that you are a business. If money is going to lose value, then you don’t want to sell your product today, instead you want to wait until tomorrow when you can charge double. This quickly becomes a vicious cycle that sends prices up and up. That is what was happening during the 1970’s. Now we aren’t talking about hyper inflation here in the United States. But the rate peaked above 10% on an annual basis twice during this time period. Most economists agree that a healthy rate of inflation for an economy is about 2%.

Enter Paul Volcker. Sworn into office in August of 1979 as inflation was on a steady and what appeared to be an unstoppable increase. But as Chairman of the FOMC he knew that there was something he could do. He would declare war on inflation, or in his very words, quote, “We meant to slay the inflationary dragon”. Using the control that the FOMC has over the direction of interest rates Chairman Volcker directed the New York Fed to raise interest rates on the Federal Funds Market. The rate would quickly rise to over 15% as he clamped down on the supply of money (meaning he took money out of the Fed Funds Market by selling government bonds).

This high increase in interest rates, along with a few other policies (you can read more about them in his book Changing Fortunes) changed the direction of inflation. There was a sharp recession that began in the first few months of 1980. However, inflation finally did fall to more sustainable levels and the economy was able to recover and begin to grow again. This would not have been possible without the decision by the FOMC to raise interest rates.

Paul Volcker received a lot of push back from politicians and workers negatively affected by the recession that was sparked by the rise in interest rates. The Museum of American Finance says the following about an artifact that they have. It summarizes nicely the reality of raising interest rates and the lives that central banks affect, “During his tenure, Volcker experienced more political attacks and public protests than any other Fed Chairman, mostly due to the effect of his high interest rates on the construction and agricultural industries. In protest, farmers blockaded the main office of the Board of Governors with their tractors. [A] piece of 2x4 wood was mailed to Volcker’s office as a part of a protest by building contractors and carpenters, who claimed their lumber was unneeded since no one was buying houses. Although Volcker is now widely credited with stabilizing the economy in the 1980s, these protests show the complexities of managing a national economy, as changes in policy are not necessarily universally beneficial. Volcker’s policies steered the US economy out of a period of high inflation and slow economic growth by severely raising interest rates.” When Ben Bernanke became the chairman Paul Volcker gave him that piece of wood as a reminder to never forget the implications of the policies being made by the Federal Reserve. We’ll talk more about the life and work of Paul Volcker in future episodes.

Conclusion

But that does it for today. This week’s episode was a little more complex and technical than previous episodes. But I really believe that if you want to understand why central banks are so important to the world economies and how that impacts our daily lives, it’s critical to understand, at least on a basic level, how central banks accomplish their work. I hope that this episode has provided that basic level understanding of how the Federal Reserve, through the FOMC, controls the direction of interest rates. If you really want to understand how this works, go out and tell a friend or family member about what you’ve learned on today’s episode. As you describe the inner workings of the FOMC, not only will you be exceptionally impressive, but you will solidify what you have learned in this episode.

When you do this, reach out and tell me how it went. And as always send in your comments, recommendations, or questions about the The Bankster Podcast or the Centralverse in general. You can email me, alexander@thebanksterpodcast.com. Find me on twitter at the handle alexbagehot. At my website www.thebanksterpodcast.com you can find a transcript of today’s episode with links to all of the sources I used in creating the content.

I’d like to thank those of you that wrote a review last week. Thanks to JD Stein who said, “Excellent discussion on central banking both past and present. My current favorite podcast”  So far the podcast has only been published on iTunes. Before the next episode I’m going to be expanding into other podcast listening platforms. Today’s episode was written, edited, and produced by me, Alexander Bagehot.

I dedicate this episode to Kerry Webb, the professor that encouraged me to study financial economics. And to all of you, thanks for listening. I’m Alexander Bagehot, and I’ll see you next time on The Bankster Podcast!

 

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