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The Fed Is Losing Control of Monetary Conditions

Mark Gilbert is a Bloomberg View columnist and writes editorials on economics, finance and politics. He was London bureau chief for Bloomberg News and is the author of “Complicit: How Greed and Collusion Made the Credit Crisis Unstoppable.”
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The Federal Reserve's next monetary policy decision, scheduled for Sept. 21, will be a non-event, according to the futures market, with about an 80 percent chance that the central bank will leave interest rates unchanged. But the unintended consequence of a rule change involving U.S. money-market funds means borrowing costs in the real world are already surging by enough to produce tighter monetary conditions even if the U.S. central bank sits on its hands.

The Fed's December move to increase its target rate -- the first tightening since 2006, and the only change of any kind since 2008 -- is unlikely to be repeated this year, based on the bets traders are making in the futures market. You have to look all the way out until the middle of next year before the likelihood of a rate hike surpasses the 50 percent mark:

Central banks adjust official short-term interest rates to steer their economies into faster or slower lanes. Make borrowing cheaper and consumers and companies will hopefully spend and invest, accelerating growth (and possibly inflation); make it more expensive, and the ensuing cutbacks will curb inflation and cool an overheating economy. But if the cost of three-month money -- the benchmark that influences many loans that aren't borrowed at a fixed rate, ranging from car financing to mortgages to corporate loans -- doesn't reflect the official level set by the central bank, then the steering wheel becomes disconnected:

The explanation for why Libor -- the rate at which banks lend money to each other -- is becoming unhinged from other borrowing costs is simultaneously simple and complex. The simple explanation is that a change in the U.S. rules governing money-market funds is driving investors who manage about $600 billion into government securities and away from non-government assets. (Click here to read more.)

The complexity emerges because the ripples from that change are showing up in different parts of the market in different ways. The rate on 90-day dollar commercial paper -- short-term borrowing by U.S. companies -- has jumped to 0.75 percent from 0.57 percent in February; but the three-month government Treasury bill rate has dropped to 0.26 percent from 0.3 percent in the same period.

As far as dollar Libor is concerned, though, the "why" of the increase is less interesting than the "what." The U.K. Treasury estimated at one point that Libor rates in various currencies and for different tenors were the basis for valuing $300 trillion of global securities. And while the various scandals surrounding Libor rigging by traders and investment banks have undoubtedly undermined its status as the world's most important borrowing cost, it still has a big influence on the cost of money in the real world.

On that basis, the U.S. has already had an interest-rate increase. The rise in Libor tightens monetary conditions. And while there are plenty of market participants who favor the Austrian school of economics and would welcome the removal of central banks from the rate-setting mechanism, the change in money-market conditions is something the Fed should take into account as it ponders its next move.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Mark Gilbert at magilbert@bloomberg.net

To contact the editor responsible for this story:
Therese Raphael at traphael4@bloomberg.net