Why the Fed Will Have to Do More Than Just Raise Interest Rates

March 26, 2015 Updated: March 26, 2015

The Federal Reserve will probably raise interest rates later this year, and foreign central bank policies may compel it to sell off Treasurys and mortgage-backed securities—reversing quantitative easing.

Historically, the Fed raises interest rates on Treasurys Securities and corporate and personal borrowing by pushing up the federal funds rate—the overnight rate banks pay for ready cash.

Longer rates are generally higher than short rates and reflect expectations about future inflation and economic growth. If the Fed acts soon enough—anticipating inflation and growth—it can push up long rates by raising the federal funds rate.

For several years now, borrowers have enjoyed low rates across the whole range of maturities, and this has distorted asset markets and economic growth—encouraging excessive investment and borrowing in some activities at the expense of others.

For example, banks specialize in borrowing on a short-term basis (issuing CDs) and lending for the long term (financing corporate debt and mortgages), and currently the spread between the five-year CD rates and 15-year mortgages is about 1.65 percent. Bankers need wider spreads on loans—up to 3 percentage points—to cover risks and earn a return on capital. Narrow spreads encourage more reliance on bank fees and riskier activities like speculation in commodity and foreign exchange markets.

Cheap mortgages financed by Fannie Mae and other government lenders have fueled strong property appreciation in more fashionable neighborhoods of New York and other urban locales, even as half the homeowners in Atlanta and elsewhere remain underwater, owing more on their property than it would generate in a sale. Agricultural land values are similarly inflated.

Cheap rates on high-grade corporate bonds have inspired some firms to buy back stock with borrowed money, increasing their vulnerability during the next recession, and encouraged ordinary investors to purchase riskier junk bonds to obtain decent yields.

When the Fed permits interests rates to rise in line with historic norms across the entire range of maturities—across the “yield curve” in the parlance of finance—current prices for some stocks, penthouses, and cropland may prove unsustainable, and lots of companies with poor business models will follow Radio Shack into bankruptcy.

The longer that long rates are suppressed, the tougher it will take to get banks fully back into the mortgage lending business and lessen reliance on federally owned Fannie and Freddie. And the greater will be the pain for property owners and savers who foolishly bought bonds issued by weak companies.

In 1994 to 1995, both Fed policymakers and bond investors were fearful that surging commodity prices would push up inflation, and the whole range of interest rates moved up when then-Chairman Alan Greenspan quickly increased the federal funds rate.

In the mid-2000s, the Fed signaled less urgency, and medium- and longer-term interest rates did not rise as much when then Chairman Ben Bernanke pushed up the Fed funds rate. Foreign governments—in particular, China—were buying Treasurys to suppress the dollar exchange rates for their currencies.

Peter Morici, professor at the Robert H. Smith School of Business at the University of Maryland, is a recognized expert on economic policy and international economics. Previously he served as director of the Office of Economics at the U.S. International Trade Commission. Follow @pmorici1.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.