The Federal Reserve needs to stay put on rates

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The author previously held the position of the head honcho at the US Federal Deposit Insurance Corporation and currently holds a prestigious role as a senior member at the Center for Financial Stability.

The US Federal Reserve should feel validated in its choice to halt the increase of rates during its meeting last month. However, it appears inclined to once again raise them, which could potentially snatch failure from the hands of success. Presently, it would be wise for the Fed to remain steadfast and maintain the current rates.

Global warming could be causing oppressive heat, but the United States is experiencing a decrease in inflation. The consumer price index only increased by 3 percent in June, a significant drop from its highest point of 9.1 percent in June 2022. The rate of growth in producer prices also decelerated at a rapid pace.

Persistent rises in housing and service expenses have considerably decelerated. Additionally, a distinct examination conducted by Morgan Stanley using fresh lease information indicates that residential rents are actually decreasing in certain instances. Moreover, the economy continues to thrive, with a low unemployment rate of 3.6 percent. In the month of June alone, a noteworthy 200,000 new job positions were generated.

These patterns offer optimism that inflation can be significantly diminished, if not vanquished, without suffocating the economy, as long as the Federal Reserve does not exceed the mark.

In the last 15 months, the Federal Reserve has been increasing interest rates at an alarming speed. They have raised rates from almost zero to higher than 5 percent. By April, a widely used measure of the amount of money in circulation, M2, had decreased by 4.6 percent compared to the previous year. This is the largest decrease since the Federal Reserve started officially tracking M2 in 1959. The economy requires a period of adaptation to these significant changes in monetary conditions, especially considering that the Federal Reserve maintained near-zero interest rates for a period of 14 years.

The economy appears to be adapting for now, but there are still a number of uncertainties on the horizon. There are trillions of dollars in corporate and commercial real estate investments that have yet to experience an increase in interest rates, but they will have to be refinanced in the coming years. Despite households still having some financial buffer from savings during the pandemic, they will soon begin to feel the impact of higher loan expenses once those funds run out. Although the job market is still strong, there has been a noticeable slowdown in private sector employment growth.

The working class and small enterprises face a high level of vulnerability in case there is a sudden escalation in interest rates, which can result in more financial troubles for banks. Consequently, this puts additional strain on local and neighborhood banks.

The main concentration of the Federal Reserve on increasing rates in the short term has led to a peculiar situation in the market known as "yield curve inversion". This anomaly occurs when the cost of borrowing in the short term is actually higher than the rates for borrowing in the long term. If this continues, it poses a serious threat to smaller banks whose profits rely on their capacity to utilize short-term deposits to provide longer-term loans at higher rates.

If the Federal Reserve indeed decides to increase rates, which appears to be a definite possibility during the upcoming meeting of the Federal Open Market Committee, they might lessen the effect by solely raising rates on the reserves held by banks. Meanwhile, they would maintain the rate paid to money market funds and other financial intermediaries that are not banks.

With the implementation of fresh measures bestowed upon it by Congress in 2008, the Federal Reserve is now capable of amplifying the interest it grants to financial institutions for their reserve accounts, whenever it desires to elevate rates. Such a system encourages banks to maintain their reserves with the Fed, unless they can secure a greater, risk-adjusted profit by extending loans to borrowers.

In 2013, without the approval of Congress, the Federal Reserve established an "overnight reverse repo facility" - a system that functions like a reserve account for non-bank intermediaries including money market funds. This facility offers interest rates that are nearly equivalent to those paid on bank reserves, providing non-banks with a motivation to leave their money inactive with the Federal Reserve.

Although initially intended to be restricted and short-lived, ONRRP has unexpectedly expanded into a massive $2tn program, resulting in financial instability as it depletes bank deposits.

Reducing the interest rate on ONRRP compared to the rate set by the Federal Reserve should prompt money market funds to reallocate some funds away from the facility and towards investments that fulfill the financial requirements of our economy. This would dampen the negative impact of a potential interest rate hike and also enhance the stability of banks, as a considerable portion of those funds would be redirected back into bank deposits.

The Federal Reserve is confronted with challenging decisions, however, we are aware that additional restrictions increase the likelihood of an economic downturn and instability in the financial sector. If the Federal Reserve proceeds with tightening, it must seek methods to lessen the consequences. Similar to how the Federal Reserve incorrectly assessed the inflation risks posed by its relaxed monetary policies, it must not now undervalue the potential consequences of its stunningly rapid tightening. The most secure option is to maintain the current situation.