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arkadiusz-sieron

Is Fed Preparing to Raise Interest Rates?

July 8, 2015, 7:25 AM Arkadiusz Sieroń , PhD

Three weeks ago, the Federal Reserve Board approved a final rule amending Regulation D (Reserve Requirements of Depository Institutions). What does it imply for the future Fed’s monetary policy and the gold market?

On June 18, the U.S. central bank announced that the changes in interest on excess reserves (IOER) would take effect immediately upon approval, rather than at the end of a two-week maintenance period. At first glance, this modification does not seem to imply any serious consequences, but in reality it is the first step towards raising the federal funds rate. Why?

The reason is that IOER is used to counterbalance or sterilize the ultra-low federal funds rate. Because the Fed pays higher interest on excess reserves (0.25 percent) than the effective federal funds rate is (currently around 0.13 percent), commercial banks do not loan out massively all that easy money obtained from the Fed, but rather hold it in excess reserve accounts, which are perceived as risk-free. By the way, this is a reason why the massive monetary base pumping did not cause significant price inflation – the newly created money did not enter the market, but was kept by the banks in excess reserve accounts.

Now, it should be clear, why the Fed changed its policy. If the Fed decides to raise the federal funds rate, for example to 0.50 percent, while it could not change immediately the IOER, commercial banks could start drawing down the excess reserves. Thus, without its recent policy change, the Fed could not control the money supply for two weeks and trillions of dollars could enter the market during this period, exerting significant inflationary pressure. Moreover, without an immediate and proportional change of IOER, the hike of federal funds rate could simply be ineffective, because the increased supply of loanable funds would exert downward pressure on interest rates.

What is also important is that this new policy will take effect on July 23, or a few days before the July FOMC meeting. This means that a July rate hike is technically on a table, although it is rather unlikely that the Fed will increase interest rates before September.

Summing up, the last change of the Fed’s policy on IOER is the first step towards raising the federal funds rate. This means that central bankers really consider an interest rate hike this year, which should be rather negative for the gold market. However, investors should remember that the possible tightening would be rather soft and gradual, therefore the impact of the federal funds rate hike on the gold prices would be milder than in the case of a sudden lift-off.

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Arkadiusz Sieron
Sunshine Profits‘ Gold News Monitor and Market Overview Editor

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