Is the Fed Losing Control of Interest Rates?

One of the keys to the mainstream’s faith in the financial system is the belief that the Federal Reserve is actually capable of managing interest rates. The Fed eases policy to lower interest rates and tightens policy to raise interest rates. But what happens if the Fed loses control of interest rates? What happens if the Fed’s purchases and sales of assets fail to have the anticipated effect on interest rates? That possibility never seems to occur to most people, yet as the Fed becomes more active in controlling the economy the likelihood of the Fed losing control and markets doing their own thing becomes higher and higher.

We may be seeing that occurring right before our very eyes, as the effective federal funds rate has been higher than the interest on excess reserves for the past month. The federal funds rate is the overnight rate at which banks can lend their reserve balances to each other. The interest on excess reserves (IOER) is the interest rate the Fed pays to banks on their excess (greater than required) reserves. The IOER is supposed to be set at about 15 basis points above the lower bound of the federal funds rate, which is currently targeted at 2.25 to 2.50 percent.

The federal funds rate is always supposed to be lower than the IOER rate, as the federal funds rate is supposed to set the floor for all interest rates. If it rises above the IOER rate it means that the Fed risks losing control of rates. There have been a few instances in the past in which the Fed has briefly lost control for a day as interest rates spike, but that was back when the federal funds rate was near zero. For the federal funds rate to exceed the IOER rate now and push towards the upper bound means either that the Fed is losing control over market interest rates, or it is looking at another rate increase in the near future.

Neither one of those are great for markets, as the Fed losing control of interest rates would send Wall Street into a panic. But another interest rate hike would similarly cause panic, as Wall Street is expecting the Fed to pause its interest rate hikes. Another hike could be the straw that breaks the camel’s back and precipitates a meltdown in stock markets.

Keep an eye on this spread between the federal funds rate and IOER. If it continues to grow, take that as a sign to diversify your portfolio, minimizing your exposure to stock markets and picking up more gold to hedge against financial risk. Market crashes don’t come out of the blue, they’re often telegraphed well in advance to those who know what to look for. And now you know what to look for.