Saturday, December 12, 2015

The effect of a rate increase coming out of the Fed's Dec 2015 meeting

The emerging consensus (here, or in summary here) is that the Fed will/should "raise rates" after its December meeting. This is probably a bad idea for reasons that fall outside the realm (scope) of the information equilibrium model -- the IEM actually says it probably won't matter until reserves get down to pre-2008 levels.

There is one issue here: since the current rate is actually a ceiling (0.25%, here) and a floor (0%, here -- and my vote for most boring FRED graph), what does "raise rates" mean? Assuming it'll just be a 25 basis point increase [1], we have three options:
A. Raise the ceiling?
In this case, nothing should happen. Market rates are already below the ceiling, so it shouldn't make a big difference. However, instead of fluctuating between 0 and 0.25%, rates will fluctuate between 0 and 0.5% -- a slightly higher average.
B. Raise the floor to the ceiling?
This would return to pre-2008 where the Fed had a single target rate, so I kind of doubt they'd want to give up newly normalized flexibility (hence more likely that they take option C below). It would would probably be an "effective" 10 basis point increase because of the current effective Fed funds rate
C. Raise the floor and the ceiling?
In this case we get a new ceiling of 0.5% and a new floor of 0.25%. As the market seems to oscillate between the current floor and ceiling, I'd imagine it would oscillate between this new floor and ceiling ... resulting in an effective 25 basis point increase.
Now that we have these contingencies, I can make a prediction of what will happen to the monetary base (assuming the path of NGDP remains unchanged). To do the averages (e.g. between 0.25 and 0.5), I took the average of the logarithm (using the lowest observed Fed funds rate of 0.04 as a floor). That means:

No change (0) = EFF of 0.1%
Scenario A = 0.14%
Scenario B = 0.25%
Scenario C = 0.35%

I also added 1% and 2% for reference.

Note that if the monetary base goes to the levels corresponding to these rates (barring a sudden change in NGDP), it would represent a pretty remarkable success of the interest rate model functional form:

log(r) = c log(NGDP/MB) + c log(k)

with c = 2.8 and c log(k) = -11.1 (these are the same values as other places I've presented them, just written in a different form).

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Update 12/13/2015

Calculated Risk says that Option C looks like the analyst consensus.

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Footnotes:

[1] There is the possibility of raising the ceiling by more than the floor. But I'll ignore that here.

4 comments:

1. For the monetary base to go down the fed needs to be selling the bonds they are holding. Do you think they can be a net bond seller at these low rates? How else could the monetary base go down?

1. If interest rates are going up, investors don't want to hold bonds. So how can the Fed be a net seller? Seems like a problem.

2. Sorry -- I missed this comment while I was on vacation.

It looks like repo agreements are how the base is reduced without changes to the balance sheet:

https://twitter.com/dandolfa/status/687016405451931649

3. I should say reverse repo

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