While the school year may be over, current events don’t stop. The focus over the summer will be elaborating on the topic for better understanding. First up, the Fed’s most recent rate hike.

EconExtra is a series of posts that go beyond the textbook, relating current events and recent developments in economics to content standards, and providing resource suggestions to help you incorporate the current events into your lessons.

The Headlines

In an effort to dampen inflation, the Federal Open Market Committee voted to increase the target interest rate by 75 basis points to a range of 1.5-1.75% on Wednesday, June 15. This was the largest rate hike since 1994, and the Fed expects the targeted rate to at least double before leveling off. (AP) Powell had signaled after the last FOMC meeting that another 50 basis point hike was likely (this is referred to a forward guidance), but economic data received since then led the Committee to determine that a larger increase was prudent.   The hope is that increasing interest rates will slow demand and halt some of the inflationary pressures attributed to demand exceeding supply.

(For an Activity related to the June 15 meeting and Press Conference, check out the 6/16 EconExtra on How the Federal Reserve Policies are Impacting Personal Finances.)

The Issue: Is this a big deal?

“Stagflation” and “recession” are terms thrown out by those who feel the nagging inflation and rate increase put us in more danger here. The Fed disagrees:

"Yet Powell largely stuck to his previous reassurances that — with unemployment near a five-decade low, wages rising, and consumers’ finances mostly solid — the economy can withstand higher interest rates and avoid a recession."(AP)

All interest rates will inevitably rise as a result. The obvious issue for most is who gains and who loses with a Fed rate increase? NPR answers that question. Depending on your personal situation, you can decide whether you will be hurt or helped by it.

• Mortgage rates rise quickly, and the 30-year rate is now over 6%, so obvious losers are those trying to buy (and finance) a home.
• Interest rates on savings accounts are beginning to increase, so savers are “winners.” (Note, however, that an interest rate of 1% or higher doesn’t do much to offset the inflation rate of over 8%.)

Over the short-term, all of us are bound to feel some pain at some point from these rate increases. Inflation is at levels we haven’t experienced in quite some time, and is certainly impacting everyone. We in the US are not alone in experiencing inflation. It is worth acknowledging that many of the factors driving inflation are beyond the control of the Central Bank and the government more generally.

The second issue that may not be making it into popular media but is being discussed at more academic levels surrounds the impact of the interest rate increase on the Fed’s Balance Sheet. (The 1/29/22 EconExtra would be a good place to start if you want more background on the Fed Balance Sheet.) This issue is explained expertly and accessibly in this article by William English and Donald Kohn for the Brookings Institution. This article explains how and why it may not be very long before the Fed starts to experience losses related to their balance sheet.

Here are the components of the Fed Balance Sheet. An (i) next to an entry represents a balance that pays interest to the Fed (assets), or a balance on which the Fed pays interest.

The balance sheet totaled about $4 trillion when the Fed began its most recent round of Quantitative Easing in September of 2020. That balance is currently closer to $8.5 Trillion. The Fed has been receiving more interest than it has been paying on reserves (Projected SOMA Net Income). The net interest earned goes back to the Treasury. The amount of this remittance has been at around $100 billion.

This graph presented in the Brookings article projects these earnings under different scenarios. The article goes on to answer anticipated questions concerning a potential shift from net earnings to net losses. This question and corresponding answer get to the heart of the issue.

“SHOULD THE FED WORRY ABOUT POSSIBLE LOSSES IN SETTING MONETARY POLICY?

The Fed is not a profit maximizing institution. It is not a bank or a hedge fund. It is, rather, a public institution with public objectives. The Fed’s monetary policy objectives, as set by Congress, are maximum employment and stable prices. And Congress has given the Fed tools to use to foster those objectives, including the ability to control short-term interest rates and the authority to purchase Treasury and agency securities. While purchases of longer-term securities can, in some circumstances, lead to losses for the Fed, the Fed’s mandate is neither to make profits or to avoid losses. The Fed should use its tools to achieve its mandate.”

Digging Deeper

If you care to take a deeper dive into the Fed Balance Sheet and the accounting behind it, here are a couple of resources for you to pursue. If you would really like to dig into the Fed Balance Sheet, the source of the graph reproduced here is from publicly available document: Federal Reserve Bank of New York Open Market Operations (2021) Annual Report. And this Fed article from 2018 explains exactly what it means if/when the Fed experiences these unrealized losses. This was the most recent time this phenomenon occurred.

About the Author

Beth Tallman

Beth Tallman entered the working world armed with an MBA in finance and thoroughly enjoyed her first career working in manufacturing and telecommunications, including a stint overseas. She took advantage of an involuntary separation to try teaching high school math, something she had always dreamed of doing. When fate stepped in once again, Beth jumped on the opportunity to combine her passion for numbers, money, and education to develop curriculum and teach personal finance at Oberlin College. Beth now spends her time writing on personal finance and financial education, conducts student workshops, and develops finance curricula and educational content. She is also the Treasurer of Ohio Jump$tart Coalition for Personal Financial Literacy.