The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

Interest Rates – Part One

12/20/2018

There are many definitions of interest rates.  One is that interest rates are the price or cost of liquidity.  As liquidity increases, the cost goes down.  (The supply of liquidity is greater than the demand for it.)  As liquidity decreases, the cost goes up.  (The demand for liquidity is greater than the supply of it.)

One of the factors pushing our interest rates up is that we are decreasing the Fed’s balance sheet.  As background, while recovering from the global financial crisis, the Fed began Quantitative Easing (QE) by buying Treasury bonds and mortgage-backed-securities from the open market.  Each bond then became an asset on the Fed’s balance sheet, and the cash paid to the seller by the Fed became a liquid asset on the seller’s balance sheet, increasing their liquidity.  Eventually, the Fed’s balance sheet swelled to a whopping $4.5 TRILLION — much too large!

In October of 2017, the Fed began Quantitative Tightening (QT) by  selling about $25 billion of their bonds each month.  When they did so, the asset came off the Fed’s balance sheet, and the Fed received cash.  That was draining $25 billion of liquidity out of the market each month.  In October of 2018, they increased the sales to $50 billion a month, draining even more liquidity out of the market.

The Fed could relieve some upward pressure on interest rates by reducing the monthly drainage of liquidity.  Certainly, we need to reduce the Fed’s balance sheet but not so rapidly.  The stock market was hoping to hear exactly that from Fed Head Powell but didn’t . . . contributing to a 352 point loss in the Dow.

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