It ought to come as a surprise to nobody who follows the economic news, but the US Federal Reserve decided that its interest rates would remain unchanged after its latest two-day meeting. Rates have been “near zero” since 2008 as the Fed battled to stimulate the US economy through an accommodative monetary policy. Whilst the quantitative easing (QE) measures that the Fed used to keep borrowing costs on mortgages and government debt low and inject cash into the economy have come to an end, the fact that interest rates are still way below historical average values indicates the magnitude of the troubles caused by the Global Financial Crisis. It is believed that QE boosted the value of assets on the Federal Reserve’s books from $1 trillion in 2007 to $4 trillion today. This was achieved by electronically creating cash to buy the assets that the Fed holds, thereby creating demand for these asset groups and pushing down their yields. The injection of “real” cash into the economy comes from the commissions that the Fed paid to financial houses to make the purchases on its behalf.
What will happen to the money?
So far, QE appears to have worked to a greater or lesser extent, but it does raise an interesting question about the fate of the electronic money “generated” to fund it. Originally, it was suggested that the money would be eliminated from the economy after QE ended, but little has been said of this in the interim. The additional $3 trillion of assets on the Fed’s books will, of course, be generating real cash from the interest that the bond issuers promise to pay on their notes – interest the Fed would not have earned if it did not create “magic money”. In the longer term, if governments decided that the allure of free money was simply too great, in these days of unpopular austerity, they could be tempted to fresh QE, or to allow the magic money to continue to exist long after its “sell by” date, if you will, has past. Potentially, such a move could derail trust in fiat money around the world which would spell financial Armageddon.
The Fed’s decision on interest rates is unsurprising since the pace of expansion of the US economy faltered badly in Q1, although analysts are confident that this was a simple blip and normal service will be resumed for the rest of 2015. Equally, inflation has been very soft and whilst fears of the consequences of deflation are overblown, it is well below the Fed’s target value of 2%. Pushing up interest rates could make businesses more reluctant to borrow (frankly, this is unlikely because borrowing cost would still be historically cheap after any likely Fed rates hike) and ought to rein in inflation – which is already “too low”.
Rates must rise at some stage, if only to give central banks some room to manoeuvre in the next economic down cycle, but it will not start for some while yet. A rate hike has been on the cards since the Federal Reserve ended the Taper last October with pundits expecting it to rise by the end of 2014 or by spring 2015 at the latest = it hasn’t happened yet.