Monday, January 8, 2018

The Fed cannot just raise interest rates. Here's what really happens.

The Federal Reserve has a duty to the American people to keep inflation under check.  To do that, one of the few tools in its box is to raise the interest rates that banks pay on overnight loans from other big banks. 

Hold on, though.  It can't do that.  This is a free market. 

People think that the Fed just raises interest rates.  We don't think anything of it because that's how the press reports it.  We all think it must just make the decision at its monthly meeting on where rates should be, higher or lower or stay the same, post the new rate on it's website, and everybody has to charge that rate until further notice. 

That is not at all what happens.  This truly is a free market, and interest rates are part of that.

Here's how it works.  If the Fed sees that inflation is becoming or might become a problem because the economy is heating up (meaning we're buying more and corporations are manufacturing and shipping more, and perhaps hiring more people, and maybe even building more factories, etc.), it decides to slow that economy to avoid significant increases in consumer prices.  (After all, that's what inflation is.)  Those corporations borrow money to build those additional factories and hire more people, so they're very sensitive to increases in the costs to make those goods.  The public also decides to buy those products partly on the costs, and if the cost is getting too expensive, the goods stay on the shelves, and therefore the corporations slow production. 

The Fed knows that those companies will slow down a bit if the cost of borrowing money increases, so it does what it can to make that money more expensive.  It does that by deciding to sell less money (Treasuries), which are sold on the auction block on a very scheduled basis.  When there are fewer Treasuries to buy, the price at auction will increase, thereby increasing the cost of money.

Since the Fed has been doing this for the entirety of its existence since 1913, it has a lot of data about how much these decisions will impact those interest rates, and it's gotten very good at it.  It knows from experience how much to restrict the amount of money on the block to effect a 1/4% change.

That said, when you hear that the Fed has raised interest rates 1/4%, that means it has decided to sell a specific amount less than it has been, and the result it intends will be that the banks will pay about 1/4% more.  It may end up being a little less or a bit more, but it will be close.

That's called free market.  So when you hear that the Fed has raised interest rates, don't believe it.  It's actually decided to sell less money, hoping that the effect will be an increase in rates.

Just a fact that you can now use at the next dinner gathering.  We should all be as well educated about these things as we can be.

Meanwhile, if you're thinking about selling your home this year and moving into the home you really want, call me.  We should get together and talk.

Enjoy the day,
Mike Moger
WK Real Estate
303.541.1920 office
303.859.4467 mobile
mmoger@wkre.com 

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