Joe Barbieri
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Joe Barbieri in Joe the Investor,

Why Is It So Hard For the Fed To Raise Interest Rates?

The Federal Reserve Board has been signaling a rise in interest rates for the last couple of years. Each time they get close to doing it, there is a market correction or an economic crisis that delays the action. The most recent occurrence in August 2015 featured both as world markets declined 10% or so with the Chinese economy being the “crisis”. Why has raising interest rates been so difficult?

Federal officials do not like market panics. There has to be a semblance of control over the markets at all times or there may be extreme movements and huge gains or losses that can cripple the economy. The reason why control is so important is because the system is built on confidence by its citizens. Should this confidence be lost, the system will fail. Evidence of this desire for stability is in the use of market circuit breakers, suspending trading when losses get large, banning short selling, limiting capital flows and introducing bail-outs and bail-ins when institutions fail.

The second factor is leverage and the reliance of the market players upon each other. The four letter word underlying this concept is debt. An exaggerated use of debt is derivatives. Since the derivative market is so huge, and the payment for these contracts is largely with leverage or debt, a large movement in the price of any security will bankrupt most of the market players. Imagine a high stakes poker game where every player is borrowing from every other player to make their bets. What will happen when one of the players cannot pay? The game will go into default and any money won will be wiped out for all the players. Since the players in this game are representing the average citizen, the whole economy would suffer under this scenario.

Will interest rates ever be raised? The difficulty this time is that the effect on the markets will be much larger than it would have been in past contraction cycles. Looking at 2008, the effect of the magnification of debt played a large role in the huge losses that manifested in a short time. The debt and derivatives markets have expanded since then. Is there anything that can make it easier to raise interest rates? It is a matter of reducing the leverage and settling payments with money based on present production rather than future production or debt. The markets should also be allowed to correct if that is what is needed to rebalance the economy to reflect what is actually going on rather than incurring distortions in the currency measuring its growth. These distortions are caused by debt that is backed by an indeterminate future production.