Why the U.S. can’t raise interest rates

I found a very compelling argument, backed by some interesting data the other day on why the Fed is handicapped when it comes to rate increases, notwithstanding the current chatter around the Fed going silent.

Dickson Buchanan, SchiffGold Precious Metals, wrote an interesting piece I would like to share. In it, he effectively spoke about how the Fed has shifted its asset duration away from short term to long term, while its liabilities are all short term. Anyone knowing anything around Asset Liability Management, knows this is a game that works as long as short term rates stay low. I will let Dickson do the rest of the talking:

"Think about the balance sheet of the Fed. Its assets are a mixture of government bonds, Treasury notes, and mortgage-backed securities. The dollars that the Fed issues to purchase those assets are its corresponding liability. Needless to say, it has purchased a lot of bonds since 2008 (QE1, QE2, QE3). So since 2008, its balance sheet has expanded on both sides.


This isn’t yet a problem, because of the duration of its assets and liabilities. Most of its assets – the bonds and mortgage debt – are long-term, with a rough average duration of over 10 years. Meanwhile, its liabilities are all short-term, current liabilities. These are deposited at the Fed by various banks, and the banks can demand them at any time.

Longer duration loans pay a higher yield than short-term loans and deposits. Since interest rates are at historic lows, the Fed can continue to borrow short and lend long – and it makes a nice profit doing so.

Here’s an example with some simple math. The yield on a 10-year bond is 2%. This is the interest the Fed receives on its loans, which are its long-term assets. On the other side, the Fed owes no more than 0.25% on its short-term deposits, which are its short-term liabilities. That’s a year-over-year profit of 1.75%. It has bought roughly $2.8 trillion of long-term debt, so that equates to approximately $49 billion in yearly profits. Not bad – as long as rates are kept low.

But the Fed wants to raise rates (or so it claims). The market is also expecting a rate hike. What happens to this game of monetary musical chairs if the Fed does deliver the higher interest rates it’s been promising?"

Any rate rise would be devastating to the Feds portfolio, as even a 1% hike would effectively reduce the market value of its long term asset portfolio (ok, you can argue they will hold to maturity), but doing mark to market, the Feds balance sheet looks a lot worse.

If the Fed is stuck in this pickle of not being able to raise rates (or not by much), think how this could impact others? As interest rates rise, the financial impact of poor working capital management is intensified through higher borrowing and capital costs

What do others think, are we stuck with low interest rates for a long, long time?

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