The decision-making body that influences baseline interest rates for all Americans, the Open Market Committee of the Federal Reserve, meets this week. Here are 13 questions and answers about what it means.
1. What’s the meeting about? Well, interest rates. But more broadly, lending, investing, and the entire economy.
2. What does the committee do? They meet eight times a year to talk about the economy, decide whether to try to increase or lower interest rates, announce their decision, and make extremely guarded forecasts about the economy. Their next announcement is Thursday.
3. All right. Why does this committee get to make decisions about interest rates? It’s the chief decision-making body for the U.S. Federal Reserve Bank. The panel is made up of 12 bank presidents and governors – including Chairman Ben Bernanke, who makes the announcement on Thursday. All the Fed regional presidents usually attend the meetings and contribute to the discussion. That includes Narayana Kocherlakota, president of the Federal Reserve Bank of Minneapolis, whose region includes Montana to the Upper Peninsula of Michigan.
4. How does the Fed try to alter interest rates and lending? It officially sets target interest rates for bank-to-bank lending and tries to influence other rates by buying certain types of securities. These interest rates are the basis for interest rates on everything else – from car payments to business lines of credit that keep shelves and factories stocked.
5. I’m still not sure what this has to do with the economy. Lower interest rates generally encourage people and businesses to borrow money and spend it, which should stimulate economic growth. High interest rates generally discourage borrowing and lead people to save money. The theory is that lower interest rates will prompt business owners to invest.
6. Aren’t interest rates already pretty low? Yes, they’re lower than they’ve been in at least 40 years. The Fed cut rates for decades, and then pushed them down to near-zero when the financial crisis hit.
7. So what’s the problem? Despite the low rates, people say the economy isn't growing fast enough and too many people don't have good jobs. U.S. quarterly GDP growth has averaged 3.25 percent for the past 65 years, and in the second quarter of 2012 we clocked in at 1.7 percent. Too slow, people say. In August the economy added 96,000 jobs, a rate that won’t quickly replace the more than four million jobs still lost to the recession. The Fed thinks if it can get banks to lend more money, the economy will grow faster and more jobs will be created. Stock market investors agree. The price of oil rose earlier this week partly on hopes Bernanke will announce action on Thursday that will get banks to lend more money and stimulate the economy. The market rallies pretty much every time it thinks Bernanke’s going to make a move.
8. What can the Fed actually do, if interest rates are already near-zero? The central bankers can buy securities from banks to influence how much total money there is for banks to lend. Twice in the past four years the Fed has tried this, and someone christened it quantitative easing. By buying different types of securities from banks, the Fed can replace the assets with new cash, which it thinks banks will be encouraged to lend. The idea is if easy money is available for banks to lend with, they’ll want to lend it and get some businesses going. It all gets very complicated, but right now the Fed has $2.6 trillion in bank debt, mortgage-backed securities, and U.S. treasuries on its books largely for this purpose.
9. Aren’t banks lending money? That depends on your perspective. Lending in America has increased compared to a year ago, but is still below levels four years ago. In all, banks held $7.3 trillion in outstanding loans at the end of June, according to the FDIC. That’s a lot, but it's still 6.5 percent less than June 2008, right as the country teetered on the precipice of recession.
10. What kinds of lending slowed down? Mostly real estate. Banks in America lend money in three large categories – in real estate, commercial and industrial businesses, and consumer loans. (They lend to farmers but that’s a much smaller portion of the banking economy than the other three.) By far the biggest area is real estate, accounting for as much as 60 percent of the national bank loan portfolio in 2008. And real estate took the biggest hit in the recession. It’s down 15 percent over the past four years, meaning there’s essentially $700 billion less real estate activity than four years ago. That reflects weakness in both housing and commercial real estate. Neither market is in terrible shape, but compared to the boom years of 2005 and 2006, the real estate market looks tepid.
11. Does anybody think interest rates are too low? Yes. Peter Fisher at Blackrock argued in the Financial Times on Monday that lending becomes less attractive for lenders when interest rates get this low, especially if there’s risk the economy will decline. If enough lenders feel that simply holding onto their money is as profitable as lending it, they will hold onto it and monetary policy won’t be able to boost the economy. That’s sometimes called the “liquidity trap,” which is what some economists believe happened in Japan in the past decade. They had zero interest rates in Tokyo in the late 1990s and a bank expanding its balance sheet at 50 percent per year, yet 12 years later the economy is still shambling along. Others who think interest rates are too low include Thomas Hoenig, a former Fed president at the FDIC.
12. Does anybody think the Fed should do another round of quantitative easing? Yes, lots of people do, maybe including Fed Chairman Ben Bernanke, definitely including Wall Street. Bernanke has left the possibility open after the past two meetings.
13. By the way, how’s the housing market doing? Not ready to weigh in on that. Check with Bill McBride. Or locally, see Jim Buchta’s Just Listed blog. The Case-Shiller home price index comes out on Sept. 25!