(cross-posted at Deny My Freedom and Daily Kos)
Today, the Federal Open Market Committee (FOMC) raised the federal funds rate 25 basis points to 5.25%. It was the 17th consecutive time that the FOMC raised the key short-term rate, but it seems that the American public had already had enough of the rising interest rates.
By a 65 percent to 22 percent margin, Americans oppose another rate increase by the central bank, which says such moves are necessary to counter inflation. The poll was conducted from June 24 to June 27, ending two days before the Fed’s latest rate decision, to be announced 2:15 p.m. today in Washington.
It makes sense that the average American would be against rising interest rates – it makes it more expensive for consumers to borrow money, and it makes mortgages on homes more expensive. Hell, even investors don’t like rising interest rates – higher rates make investment more expensive for firms, and it tends to have slow down the economy in general, especially the housing market.
What people don’t understand, though, is that the FOMC and the Federal Reserve do not base policy on popular sentiment. In fact, the very reason the Fed is independent of the government is so that it is not swayed by political or popular pressures to act in a certain way. Furthermore, the FOMC’s mandate is not to promote as much growth as possible. Contrary to what some may think, the Fed has exactly two obligations to fulfill in its mandate: promote policies that will ensure maximum sustainable employment and ensuring price stability.
When you examine the matter more closely, though, it becomes clear that maximum employment and price stability are goals that often conflict with each other. In the 1950s, an economist named A.W. Phillips noticed a strong negative correlation between unemployment; plainly speaking, when unemployment went down, inflation went up, and vice versa. If you look at the relation between these two indicators in the U.S. during the 1960s, the curve is quite distinct, and economists began to believe that we had a choice between having a strongly-run economy (low unemployment is usually a sign of a healthy economy) with high prices, or we could have lower inflation at the expense of employment.
From 1970 on, though, the Phillips curve began to show no meaningful correlation between unemployment and inflation; this has been partially attributed to the effects of the oil shocks that started in that decade. Instead, the hypothesis of the Phillips curve has become modified to become the expectations-augmented Phillips curve. This shows a fairly strong negative correlation between unexpected inflation (the difference between actual inflation and the amount of inflation that is expected) and cyclical unemployment (the difference between actual unemployment and natural unemployment – the rate of unemployment that were to occur should the economy be growing at the theoretical point of full employment). The argument, though, has been simplified, and it still holds in the general sense: there is a trade-off between a growing economy and low prices; maximum employment implies that an economy growing at a faster rate.
So how does the FOMC fit into all of this? To be truthful, the Fed is not a cure-all for the economy. In fact, they directly control only two interest rates: the federal funds rate (the interest rate at which members of the Federal Reserve banking system can lend money to each other) and the discount rate (the interest rate at which member banks can borrow money from the Fed itself; since 2003, this has been fixed at 100 basis points above the federal funds rate). However, this has a general ‘trickle-down’ effect of sorts; when the Fed rises interest rates, rates on everything – from commercial banks to mortgages – tend to move up with it. However, the interest rate has an overall impact on the economy, which I will attempt to explain in as much plain English as possible without the use of economic models.
When interest rates are low, people tend to save less and consume more – why bother saving at such a low interest rate? Furthermore, because rates are low, firms are more likely to undertake investment because financing them will be cheaper. These are factors that drive the economy, and it will generally lead to growth. As an economy grows, firms will attempt to match the increased demand for goods by producing more. While productivity will rise, there comes a point where they will hire more workers to keep up with demand. This is why employment tends to go up when the economy expands. However, as the economy begins to expand, firms have to pay additional workers, and they have to pay higher real wages for their laborers. They end up passing along these additional costs to consumers in the form of higher prices. This is why inflation goes up during times of economic expansion.
Let’s examine the case of a scenario where interest rates are high. At higher interest rates, consumers are more inclined to save their money, as they can earn a decent return by having it sit in the bank. Furthermore, because borrowing costs are higher, consumers cannot borrow as much money to fund their consuming habits. Additionally, because the cost of financing is higher, firms generally undertake less investment. Lower consumption and investment tend to produce a drag on the economy. Firms have trouble selling as many goods and services as before, and therefore, they tend to lay off workers, leading to lower employment. Since they can’t sell their products at high prices, firms are also forced to lower their prices – leading to low inflation.
As you can see, maximum sustainable employment and price stability (another way of saying low inflation) are often contrary to each other. In the present, a moderate rate of growth for the economy (as measured by GDP) is roughly defined at 3% on an annual basis. The Fed’s comfort range for inflation, although not explicitly stated, is implied to be in the 1%-2% range (why not 0% That’s another discussion for another day). As you saw above, the level of interest rates does affect the economy in a broader manner. In recent times – probably beginning with the chairmanship of Paul Volcker in 1979 – the notion of the FOMC having a dual mandate has become a more singular focus on keeping inflation under control. When Volcker became chairman of the Fed, inflation was in the double digits. He raised interest rates extremely high and was probably singularly responsible for sending the economy into a recession. However, he was able to get inflation down to acceptable levels, and we have not seen high prices of the like since. Alan Greenspan and Ben Bernanke have followed in their predecessor’s footsteps in being a ‘hawk’ on inflation – stating that they will keep prices under control, even if it means sacrifing growth. Whether or not the economy is better off by being tough on inflation instead of attempting to facilitate growth is up for debate, but one cannot argue with the fact that we have not faced a recession since then that comes even close to what was endured during the 1970s.
This may make Americans unhappy – after all, consumers in America have a negative savings rate (this means that they spend more than they earn; essentially, we fund our additional consumption through borrowing), and doing so crimps our ability to buy products. But it is not the Fed’s role is in monetary policy; it is to ensure that the economy as a whole is running well. It is the government’s role to conduct sound fiscal policy that will ensure that our standard of living is increased. Therefore, if you want to be mad at someone over the state of the economy…blame the politicians. Don’t blame the economists – because their purview is narrowly defined.