Thursday, September 27, 2012

Does the Fed Really Control Interest Rates?

The answer is not completely.

A commenter asks:
1. I have tried to make the point that rates will not go up because the FED will not allow it and other readers have commented that the FED can to control rates, only the market can. Why is it then that you state at the end of your post , "...the fed is all about keeping rates lower than they should be"?

2. When you say, "so while I expect rates to climb significantly, say to 7 percent as a first stop...", are you speaking of the 30 year fixed mortgage?
1. The Federal Reserve does not have full control over interest rates, they only have influence, that influence changes over time.

For example, at the present time, we are in a generally low interest rate environment. This is partly because of Fed money printing activities, but also because individual investors are generally afraid of stocks at the present time and prefer what they perceive as the safety of fixed income investments. (Note: They are likely to be very wrong about the safety of many of their fixed income investments.)

But suppose price inflation starts to climb, at such time there will likely be strong upward pressure on interest rates. The only way the Fed would be able to fight this is to print more money, initially putting downward pressure on rates. But the newly printed money would eventually cause even greater price inflation and even higher interest rates, so you get a tiger by the tail situation.

Interest rates may start to climb toward 7%, but the Fed prints more money causing rates to stabilize around 5%, but this causes even more price inflation and interest rates climb toward 10%. The Fed prints even greater amounts of money, which results in rates stabilizing around 7%, but the newly printed money causes rates to climb toward 12%. The vicious circle continues. The only way the vicious circle can be stopped is by the Fed stopping the printing of money and allowing rates (that they can't control completely) to peak out, otherwise its hyper-inflation.

The U.S. came near hyper-inflation during the Jimmy Carter administration when G. William Miller was Fed chairman. In a panic about the inflation and not knowing what to do, Carter asked David Rockefeller for advice. Rockefeller told him to put his man Paul Volcker as Fed chairman. Volcker stopped the crazed money printing and allowed interest rates to find their own level.

Interest rates during the Paul Volcker Fed chairman era.

When Volcker took over as Fed chairman T-Bill rates were at 9.52%. As Volcker allowed rates to rise, they peaked in 1981 at 15.51%. He started printing again in August 1982 (probably on orders from Rockefeller), and rates dropped to 8.68%. Early on in his period as Fed chairman, he had killed the inflationary fears and could get away with the new printing. But, when the inflationary fears are strong, it is impossible for the Fed to keep a complete lid on interest rates.

2. I used 7% as just an example in my mortgage example. It wasn't a forecast, though, I suspect that on a first run that is where mortgage rates, over a year or two, would stop.


  1. How is it that "individual investors are generally afraid of stocks" yet the S&P and Dow are near all time highs again?

  2. Volcker had to raise the FED funds rate to 20% in 1980 in order to quell that inflation.

    When the current multi-year bout of inflationary policy begins to manifest itself in higher prices the FED won't have that same option. Like Mises said, they have a choice between ending the credit expansion, resulting in a lot of large corporations, banks, and households going bankrupt, or continuing the credit expansion, resulting in hyperinflation. The U.S. is clearly choosing the latter. Why? Because it is the more politically expedient path. The FED believes that it will be able to reign in the inflation by tinkering around with the FED funds rate and FED balance sheet once prices begin to rise. All one can do is chuckle at such a notion. The inflationary tsunami currently swelling up on the economic horizon will by no means be contained in the champagne glass of policy initiatives.

    They have made their choice: Delay the day of reckoning for a few more years of artificial luxury. They could have stopped the credit expansion in 2008 and regrouped. Instead, they, perhaps unknowingly, chose to destroy the U.S. dollar. There are no do-overs for this choice. When the inflation starts to get out of hand and the masses begin to dump the currency for anything of real value, the FED does not get to say "OK,OK! Look everybody! We're raising interest rates now!!! The masses, like a great ocean liner, cannot be turned so easily. Ah, if only economic central planning were as easy as the FED believes it to be. Cut a few points here, raise a few points there, and viola, you have a happy, healthy, and wealthy centrally planned society. Why didn't they think of this before? We could have saved the world a lot of heartache and poverty. The devastation will be epic. It may be a few years off. It may be a few months off. Who knows when the herd will finally be spooked. All we know is that when it starts the stampede, there is no stopping it. Silver is your friend. Buy some.

  3. @Anonymous 10:45...I think there is a difference between individual investors (read: small money managers, guy on the street) and instiutional investors (read: big banks with tons of money from the Fed). Most of the things that I have read indicate that there are very few small time guys who are in the stock market, and they certainly aren't in like they used to be. It's all big firms with HFT operations. Just look at the bond yields, and they indicate that people are fleeing to "safety" in Treasury bonds. Also, ZH reported today that Fidelity reported it manages more money in bonds and MM than in stocks for like the first time ever.

  4. Robert,

    Thanks for the acknowledgment. My next question for you is, how do you see the scenario playing out with regards to the debt/deficit problem with rising interest rates? As I have pointed out, the debt service will skyrocket very quickly with the type of rate increase that you forecast.


    1. The debt will put major upward pressure on interest rates, which will most likely result in major money printing by the Fed. This will lead to massive upward pressure on prices, especially asset prices like housing.

      Higher housing prices with cheaper dollars to pay off mortgage debt is the likely outcome.