No Pressure on Interst Rates

When are interest rates going to rise?  Risk-free interest rates that is?  Short-term interest rates?

Interest rates have risen…and fallen…on government debt that was once considered risk-free because these governments have faced solvency problems. 

But, what about interest rates on United States Treasury debt?  And, what about money market interest rates?   And, what about the Federal Funds rate?

The Federal Reserve has indicated that the target Federal Funds rate will remain where it is now until the end of 20--, you put in the last two numbers. 

The upper limit of the target Federal Funds rate has been at 25 basis points since December 16, 2008.

The upper limit of the target range will only be challenged if the Federal Reserve decides to tighten up on monetary policy…something that is out-of-the-question at this time…or if business activity picks up and the demand for funds increases, thereby putting pressure on short-term interest rates to rise.

Certainly, QE1 and QE2 impacted the supply side of the market and helped to keep the Federal Funds rate below 25 basis points. 

Over the past year, however, there has been next to no demand pressure on the Federal Funds rate to rise.  Over the past year, the effective Federal Funds rate, on a daily basis, has varied between six basis points and eighteen basis points.  Although the rate has been toward the upper end of this range in the past three months, the Federal Reserve has actually seen its portfolio of securities decline over this time period indicating that there has been little or no pressure on the Federal Funds rate to rise. (See my August 7 post about recent Fed activity.)

This lack of pressure on short-term interest rates is a sign of two things at this time.  First, it is a sign of the weakness in economic growth in the United States economy and the consequent lack of pressure on the banking system to lend. 

This lack of weakness is also seen in the financial instruments with a longer term.  Mortgage interest rates are at historically low levels, yet analysts claim that they could be even lower than they are now.  A New York Times article points up the fact that mortgage interest rates could even be lower than they are now but commercial banks have not let them fall as much as they could.  The demand for mortgages is just not that strong.  

One argument given for why the banks are keeping rates as high as they are in the current market is that their costs have risen due to the new regulations that the banks are facing.

Still, the indication is that there is no demand side pressure on interest rates in the current market.

There is a second argument for the lack of pressure on United States interest rates and this has to do with the fact that the United States Treasury market is receiving a substantial amount of funds seeking a “safe haven” in a world of great uncertainty. 

The United States is not the only beneficiary of this “move to safety”.  David Wessel, in the Wall Street Journal, writes about the “subzero” interest rates that now are being “paid” on the two-year government bonds of Switzerland, Denmark, Germany, among others. 

And, we have seen a negative yield on the ten-year inflation-adjusted Treasury bond (TIPS) since August of 2011. 

The point is, that the demand for funds is close to non-existent and this is not a good sign. 

Sure, some firms are borrowing but these are generally the larger companies who are taking advantage of the very low interest rates.  But, these funds are not being used to expand plant and equipment. 

But, with the demand for funds being so low and with little or no indication that a pickup in demand will appear anytime soon, other problems exist.  Savers are earning next to nothing on their money and the many of the elderly are finding it hard to make ends meet.  And, as Wessel points out in the Journal article, “banks and insurance companies start to run into trouble.  They make much of their money by borrowing at short-term rates and lending at higher long-term rates, or effectively, guaranteeing higher rates to their customers.  That doesn’t work so well when yields on two- or three-year securities are negative.”

To me, this is a place we must look to pick up signs of an improving economy.  Demand pressure must start to build in the financial markets indicating that the economy is growing stronger.  The must be some indication that demand pressure is being felt in the Federal Funds market forcing the Federal Reserve to react in an effort to keep the effective Fed Funds rate from rising. 

This is a reason, in my mind, for opposing any kind of further quantitative easing (QE3) in the near term.  If there is no demand side pressure on the money markets, shoving more money into the banking system will not create more demand given where interest rates currently are. 

Business loan demand has been increasing slightly but there is no indication that what we have seen is significant to put any pressure on the banking system.  And, merger and acquisition activity remains week thereby providing us with another sign that the demand for financial resources is remaining tepid.

Right now the Federal Reserve has stated that it can see the Federal Funds rate target remaining in place to the end of 2014. 

If they really believe that this will be the case then they are indicating that they expect the economy to stay extremely week until that time.  This would mean that the economic recovery would be in its sixth year.  And for there to be no demand pressure on short-term interest rates during this time, economic growth would still need to be around two percent and unemployment would have to hover around eight percent.

The fact that there is little pressure on interest rates to rise is not a good sign!