As Washington DC melts down, entrepreneurs keep moving, people keep working and spending; the economy keeps growing. The Federal Reserve keeps meeting and speaking, too, but now it appears they will actually act.
Next week's Fed meeting (
However, if the Fed surprises and declines to raise rates, despite all the hints from recent Fed speakers including Fed Chief Yellen herself, it will also be major news, suggesting the Fed has an unfortunate bias against raising rates under pretty much any reasonable conditions. We don't think that's likely, but it would be big news.
Either way, investors need to focus on more than just interest rates. Rate hikes under the current monetary regime are different than any other time in history. In the past, when the Fed wanted the federal funds rate higher, it would shrink the amount of reserves in the banking system by selling bonds to banks and subtracting cash. With a smaller supply of reserves, banks would bid up their cost.
But these days, there are roughly $2 trillion in excess reserves and the Fed has no plans in motion to reduce them. As a result, a rate hike next week would push what the Fed pays banks on those excess reserves to 1% from 0.75%. The idea is that if the Fed pays higher rates, banks will continue to hold reserves and money supply growth and inflation can be contained.
This experiment has never been tried before and no one knows if it will work. In fact, there is good reason to believe it won't. An upward sloping yield curve suggests banks have more incentive to loan as rates rise, not less.
In other words, we will be watching the Fed's statement for two things. First, how quickly we can expect interest rates to rise in the year ahead, but also whether there are any plans to shrink the size of the balance sheet.