Whiting column: Power of the Fed and effect of an interest hike
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The Fed earlier this month raised its interest rate by 0.25 percent.
Who, how, why and so what?
Simplistically, the Federal Reserve Bank is the bank for banks. It is not owned by the government but rather by our country’s banks, which are all privately owned, member banks that are guaranteed a 6 percent rate of return after the Fed’s expenses are paid.
The Fed was created by Congress in 1913 and given two main decision-making responsibilities:
• Exclusive power to print money.
• Adjust monetary policy as needed through:
— Setting the bank reserve requirement, which is the percentage of deposits banks are required to keep in reserve and not invest or lend.
— Setting the discount rate (interest rate charged to banks when they borrow money from the Fed).
— Open market operations (buying and selling U.S. government securities, which are treasury notes, bills and bonds).
The Federal Reserve Board (appointed by the president with congressional approval) makes these decisions independently. Neither Congress nor the president has approval powers.
Monetary policy is used to flatten the peaks and valleys of a capitalistic economy.
If the goal is boosting the economy, the Fed will:
— Decrease the reserve requirement, which enables banks to lend more money to people and businesses. It is spent over and over, which increases business, profits, number of people employed and even tax receipts.
— Reduce the discount rate, which enables banks to lower their interest rate, again facilitating more loans and spending.
— Buying bonds from banks. The money banks receive from the Fed will increase the money supply, again facilitating more loans and spending. The Fed also sells government securities to finance our national debt.
If the goal is to slow down the economy, the Fed will do the opposite, as evidenced by the Fed this month raising the discount rate by .25 percent.
Why would slowing the economy ever be a desired goal? A logical question. Economic theory says and history supports that our economy is never stagnant. It is either moving up or down. These cycles are natural, but the problem is that the higher the highs the lower the lows. It’s not the highs we worry about, but the extreme lows with its loss of employment. Consequently, we try to knock down the highs and boost the lows to make the fluctuations less dramatic. History has also demonstrated that economic cycles move geometrically instead of arithmetically. Instead of growing 1, 2, 3, 4, etc., it grows 1, 2, 4, 8. The problem is it moves down in the same geometric fashion.
An accompanying characteristic of an economy growing too fast is increased inflation. More and more money is being spent, increasing demand and consequently price. The concern is that higher prices will eventually mean less spending, turning the economy downward. To keep this from happening, the Fed uses monetary policy to slow the economy.
We would be naïve to believe that bank profit is not a desired goal. The Fed’s owners, each private bank, want to facilitate their 6 percent rate of return. Local banks will also increase rates to borrowers increasing bank revenue.
Such an increase means a decrease in entrepreneurial activity and hence job generation. Large corporations have cash, which makes them less likely to borrow. They also have leverage because they have cash and assets, enabling them to demand a lower interest rate than the entrepreneur.
The interest rate on new federal student loans will rise. The 65 percent of existing student loans with adjustable rates will have higher payments.
Home mortgage rates will rise. Existing mortgages’ rate will rise if adjustable. This can negatively affect real estate sales, lower home values and make it harder to sell your home.
Credit card interest rates will rise, decreasing spending. Currently, credit card debt is over $1 trillion. Even a 0.25 percent increase means $2.5 billion in increased interest revenue for banks.
Historically, the higher the interest rate the lower the stock market. Investing in bonds and savings accounts become more desirable.
The rate paid on bonds and savings accounts will rise, an advantage to those with money to invest who desire a risk-free investment. Increased saving is good news and bad news. The bad news is the money is not being spent by consumers. The good news is money becomes available for future consumption, which can help the economy if it needs a boost or a job is lost.
The supply of money decreases, raising the value of the dollar in relationship to foreign currencies. Interestingly, this is a negative to our economy. It increases foreign travel because we get more for our money, but this is money not being spent, circulated and multiplied here. It also raises the price of our exports, leading to decreasing exports and an increase in our trade deficit.
Overall, prices of products and services will rise because the cost of borrowing money increases. Borrowing money is an operational reality for most businesses. The decreased spending will mean an increase in business bankruptcies and fewer startups.
These results sound negative, but remember that the goal is to slow the economy, lowering the height of the cycle.
One can argue the current situation doesn’t justify an interest rate increase.
The Fed said our economy has strengthened to the point where we need to be concerned about inflation. This may be true viewing the country as a whole, but economic recovery is not geographically universal. Those areas that haven’t recovered will feel the effects of the higher interest rate while still suffering.
Economically, a high level of inflation only occurs when personal income rises at a faster rate than the cost of living. In the past year the cost of living increased 0.2 percent; personal income increased by 0.3 percent, not an economically significant difference. Consequently, it could be argued the rate of inflation doesn’t justify an interest rate increase.
A 0.25 percent increase may not seem significant, but even that small increase will have an effect. The Fed says this is the first of four raises before the end of 2017; a total increase of 1 percent. Significant indeed.
Don’t confuse monetary policy with fiscal policy. The latter uses tax rates and government spending to manipulate economic cycles. It is determined by the president and Congress and its strategies would be another column.
It is our personal responsibility to understand our economic system, its components, how they function and their intended effect if we are to function well within it and work to improve it.
Bryan Whiting believes most of our issues are best solved by personal responsibility and an understanding of nonpartisan economics rather than by government intervention. He retired after 40 years of teaching marketing, entrepreneurship and economics.
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