Federal Reserve & Interest Rates

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.

Nearly a hundred banks have already failed this year and the FDIC’s bad bank list contains hundreds more that are in danger of failing in the next few years.  With it’s insurance fund running dangerously low, the FDIC put forward a plan earlier this month, in which banks would prepay three years worth of fees to replenish the fund.

It’s the worst stretch of bank failures since the Savings and Loan crisis of the 1990’s when nearly two hundred banks and thrifts failed, costing taxpayers over $100 billion.  The insurance fund has shrunk by nearly $35 billion since the recession began and has a little over $10 billion remaining.

While banking system has stabilized somewhat, it’s still in a fragile state and the continued weakness in the residential and commercial real estate markets will lead to more failures in the next few years.  At this point, the FDIC estimates that bank failures will cost the insurance fund $100 billion by 2013.

The proposed prepayment plan is expected to raise somewhere in the neighborhood $50 billion and while the banking industry isn’t happy about it, they prefer this option to a special fee assessment which was also a possibility. In May, Congress increased the FDIC’s line of credit with the Treasury to $100 billion, but it been reluctant thus far to borrow from the Treasury and putting more of the onus of bank failures on taxpayers.

Chairman Ben Bernanke gave an update on the status of the Federal Reserve’s balance sheet in a speech on Thursday.  Although there has been talk lately of the Fed’s impending exit strategy, fears of relapse may make that a long drawn out process.

To fight a recession, the standard prescription for a central bank is to lower its target short-term interest rate, thereby easing financial conditions and supporting economic growth. In the current downturn, however, the Federal Reserve has faced two historically unusual constraints on policy.

First, the financial crisis, by increasing credit risk spreads and inhibiting normal flows of financing and credit extension, has likely reduced the degree of monetary accommodation associated with any given level of the federal funds rate target, perhaps significantly.

Second, since December, the targeted funds rate has been effectively at its zero lower bound (more precisely, in a range between 0 and 25 basis points), eliminating the possibility of further stimulating the economy through cuts in the target rate.

The Federal Reserve has had to take unconventional steps in order to get the financial system back on it’s feet.  Normally a backstop for commercial banks, the Fed greatly expanded it’s role by providing liquidity to financial institutions across many sectors and becoming an active buyer in a number of credit markets.

It quickly saw that it’s normal monetary policy initiatives would not be enough to unfreeze credit markets in the wake of the financial panic last fall.  It’s balance sheet currently sits at $2.1 trillion and will continue to grow as the Fed finishes up with their agency mortgage securities purchases.

They do have a number of tools at their disposal to shrink their balance sheet when the time comes.  However, if the recovery starts to stall the Fed’s balance sheet could remain quite large for some time.