Federal Reserve & Interest Rates

The Federal Open Market Committee met this week and to no ones surprise left interest unchanged once again and issued a press release following their meeting.

In these circumstances, the Federal Reserve will continue to employ a wide range of tools to promote economic recovery and to preserve price stability. The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

There have been call from some circles to raise interest rates recently, most notably from former Fed Chairman Alan Greenspan.  While GDP grew once again in the last quarter, signaling the end of the recession, numerous problems still lie ahead for the economy.

The banking system is still in a fragile state, with many financial institutions hoarding cash, still reluctant to lend to consumers whose demand for credit is also well below normal levels.  The housing market, while it has had increased activity as of late, has yet to recover and that could still be years away.

Consumer spending is also way down and many household have increased their savings rate, with an uncertain labor market for the foreseeable future.  The economy is just at the start of the recovery phase but much of the positive GDP growth from last quarter was mostly due to the fact of the increased fiscal spending the government has undertaken over the past year.

It may be as much a year, if not longer before the Fed raises interest rates once again or begins shrinking it’s balance sheet for that matter.  While the Fed has to be careful about timing it’s exist strategy, with the current state of the economy, monetary easing doesn’t appear warranted just yet.

During an economic conference at the Federal Reserve Bank of Boston, Chairman Bernanke called for legislative action from Congress to close regulatory gaps,  as well as give regulators the power to unwind failing non-banking firms.  Only the FDIC currently holds such power over financial institutions with bank holding companies.

Supervisors in the United States and abroad are now actively reviewing prudential standards and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher-quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers.

On the supervisory front, we are taking steps to strengthen oversight and enforcement, particularly at the firmwide level, and we are augmenting our traditional microprudential, or firm-specific, methods of oversight with a more macroprudential, or systemwide, approach that should help us better anticipate and mitigate broader threats to financial stability.

States which regulates insurance companies and the SEC which had regulated the now defunct investment banking sector had little such power, which led to little choice last year but to let Lehman Brothers collapse and AIG receiving a massive federal bailout.  While both Citigroup and Bank of America also required substantial federal aid subsequently, much of that was due to the global liquidity crisis which ensued following the problems of the two above mentioned institutions.

While Congress has been expected to act for some time and many changes are expected in the financial regulatory structure, little has been done thus far with it’s main focus on healthcare reform at the moment.  A plan which has gained steam recently is the creation of a regulatory council made up from a number of federal agencies with the power to supervise firms deemed systemic risks to the greater economy.

There have also been many calls to break up so called firms that are “too big” to fail in order to avoid a repeat of last year where substantial taxpayer dollars were put at risk in order to rescue the economy from financial collapse.

The Federal Reserve has kept interest rates at nearly 0% for some time now and by all accounts it will remain at that level through next year.  Now over a year removed from the beginning of the financial panic, credit markets have yet to recover.

Consumers and businesses are reluctant to borrow and financial institutions are reluctant to lend, even with interest rate at historical lows.  Consumer spending has been stagnant and with demand still low, businesses are loathe to make capital investments.

Throughout the recession, the savings rate of American households continues to climb despite repeated efforts by the government to stimulate consumer spending through stimulus payments and incentive programs.  Although the economy is expected to return to positive growth this quarter, it’s been mainly driven though the government’s fiscal and monetary policy initiatives.

With it’s normal monetary policy tool exhausted, the Federal Reserve has had to use balance sheet growth to expand the money supply.  The federal government has also had to undertake massive budget deficits in order to rescue the financial system.

With the current state of the credit system, talks of exit strategies might be premature at this juncture.  Short term inflation expectations remains low but it is something the government will have to worry about in the long run.

Financial institutions are still trying to de-leverage themselves and hundreds of banks are likely to fail in the next three to four years.  Consumer confidence will also likely remain muted for some time with the labor market expected to take years to recover.

Despite the record growth of the national debt, a number of individuals have cautioned against the government reducing it’s fiscal spending anytime soon or the economy could see a series of fits and starts as it tries to recover.