How The FED Is Screwed And What To Expect Next?

People are calling the FED screwed. FED has been ambivalent in hiking the interest rates. When the conditions were right, it hesitated and didn’t increase the rate. Now when it wants to increase the rate, it may find it difficult.  Zero interest rates were a response to the worst U.S. economic crisis since the Great Depression. The economy, though, is far removed from its crisis days. The recession ended in mid-2009, gross domestic product has been on a steady if uninspiring march higher and financial markets, which have received by far the most benefit from Fed programs, have soared. While all that happened, the Fed could have begun the tightening process without disrupting the recovery.

Now the FED Chairperson Janet Yellen has said that FED will increase the interest rates gradually. This announcement has already been compounded into the price as we see GBPUSD and EURUSD shooting up  500 pips last week. It seems that this uptrend will continue and market will already include the interest rate hike before it is formally announced by the FED. The Fed signaled in its March statement that it was moving a step closer toward raising rates, though the central bank cut its economic outlook and slashed its median estimate for the federal funds rate, in a sign that it was prepared to move more slowly than the market expected ahead of the meeting.

Janet Yellen is on record to have said that expect a rate hike in June and then subsequent rate hikes will be done gradually.  “I expect that conditions may warrant an increase in the federal funds rate target sometime this year,” Yellen said Friday at a conference hosted by the San Francisco Fed. She and fellow policy makers “generally anticipate that a rather gradual rise in the federal funds rate will be appropriate over the next few years.” 

So it can be a few years before we see an interest rate like 3-4%. Right now the interest rate is almost zero. The talk of interest rate hike as said above has already strengthened the USD and investors have started to move from EURO to USD. Now when the FED talks of increasing the interest rate, it is talking of the Federal Fund Rate which is the overnight interest rate that institutions can lend funds maintained at the FED to one another. When the FED increases this rate, the banks and other lending institutions also increase the interest rate that they charge on bank loans. This increase in the Federal Fund Rate translates into an increase in the short and long term interest rates in the economy. So there is a lag of  few months before the rate hike trickles through the whole economy.

The Federal Funds Rate is often looked at as a benchmark for other interest rates and has a profound influence on overall economic activity as its level can either help to stimulate the economy or control inflationary pressures. The FOMC sets targets for the Federal Funds Rate and looks to achieve these targets through their own open market operations.

Everything has to be finely calibrated. The job of the Federal Reserve or for that matter any other central bank is not easy as said above. When the conditions were right, FED became cautious and didn’t increase the rate. The New York Federal Reserve officials tasked with prying interest rates off the floor have been meeting with bankers and traders to plot how best to do it, amid deep uncertainty over how much control they will really have over short-term lending markets.

 

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