President Donald Trump has said that the Federal Reserves (the Fed) is “going crazy.” Is he right? Let’s break down what has happened: September 2018 was a busy month for the Federal Reserve. They voted to increase the federal-fund rate to a range of 2% to 2.25%. Another increase may come possibly later this year and in 2019. Why did the Federal Reserve raise the fed-fund rate? And can this increase in interest rates truly prevent us from experiencing another recession soon? Keep reading to find out.
What is the Federal Reserve?
OK, first let’s define some terms: The Federal Reserve is an independent government agency that controls the money supply in the economy. The federal-funds rate (FFR) is basically the rate at which banks borrow money from each other. Banks deposit excess reserves into the Federal Reserve daily and earn the FFR whenever they lend any part of that money to another bank. When the Fed raises the FFR the cost of borrowing money increases. As a result, interest rates on credit cards, car loans, mortgages, etc… all go up and people become less inclined to borrow money for purchases of goods and assets. This creates less spending and thereby slows down the economy, in an attempt to rein in inflation. This course of action is pursued in order to avoid “economic growth that becomes unsustainable, leading to a boom and then bust,” as we saw in 2008.
Two Current Economic Conditions
First: the unemployment rate is the lowest it has been in decades. According to the Labor of Bureau Statistics the unemployment rate in August was 3.9%; in September it dropped to 3.7%. Generally speaking, when the unemployment rate is low, inflation tends to rise because people have more disposable income to spend. Low unemployment also creates higher wages, as employers compete for a limited talent pool in the job market. With higher wages, people become more creditworthy, and lending institutions lend money more readily.
This cycle continues to push inflation upward as more money. This occurs both in the form of credit and wages as they circulate in the market of goods, services, and assets. An untethered rise in inflation can eventually bust. This happens when people suddenly start to lose their jobs or default on their credit loans. For this reason, the Fed seeks to control this growth through monetary policies similar to what they instituted this week.
Second: Tax cuts went into effect earlier this year. In particular, businesses saw a decrease in the corporate tax rate. They use this extra money to either reinvest in their businesses or in their people by giving bonuses. However they use the funds, an additional supply of money is now circulating in the economy through millions of transactions. As we saw earlier, increased spending raises inflation because, at least in the short term, demand is higher than supply. Once again this warrants action by the Fed to restrict any uncontrollable growth that might occur.
An article published in the Wall Street Journal (WSJ) titled, As Fed Raises Rates, Consumers Have Yet to Feel the Sting, stated that many people began to feel the effects of higher interest rates even before the Fed raised the FFR. The article stated that “Average rates for credit cards…auto loans and home-equity lines of credit had all risen since June when the central bank announced a quarter-percentage-point increase in its benchmark rate and penciled in two more such moves this year”. By raising the FFR, the Fed hopes to slow down the growth of the economy and curb inflation. Already its goals seem to be coming to fruition.
The question is, however, how much restriction is too much? Also, can the Fed slow down the economy without actually causing another recession? This is the point that President Donald Trump is making when he criticizes the Fed’s aggressive interest rate increases.
How Much Restriction is Too Much?
Many people, including President Trump, are concerned. They believe that the recent hike in the interest rates is unnecessarily undoing all of the economy recent successes. This is a valid point because monetary policy can’t always predict human behavior. It is one thing to raise interest rates, which creates a disincentive to borrow money for spending. It is another to actually prevent people from borrowing and from spending. This is especially the case when unemployment is so low and wages have risen.
Another point of consideration is the recent tariffs that President Trump has levied against China. Many experts have already mentioned that the tariffs might raise prices. This is not because of increased spending by consumers. Rather, because much of the consumer goods and intermediate goods that Americans rely on actually come from China. Increased tariffs will bring higher prices. The only and unlikely way out is if China chooses to absorb additional costs of doing business with the U.S. Tariffs can put upward pressure on inflation while the Fed is raising interest rates. This can spell major disaster for the U.S. economy.
Can the Federal Reserve Slow the Economy and Avoid a Recession?
In 2008 the U.S. economy fell into the worst recession since The Great Depression of the 1920s. At that time, the housing market was booming. Banks and other lending institutions were providing loans to people who were not creditworthy. They then sold those loans in the form of securities to investors. This scheme continued for years. Eventually, homeowners, who had no business taking out mortgages in the first place, began to default on those loans. Banks were left with millions of dollars of worthless property. They did not enough cash on hand to meet their obligations. The FFR immediately prior to this crisis ranged between 4.75% in September to 4.25% in December 2007.
This is an example of how unpredictable the economy can be. Many people foresaw the housing crisis. However, there was not much the Fed could have done to prevent it once it was in full force. Remember, the Fed has been raising and dropping interest rates since its inception in 1913. And it still hasn’t solved the problem of boom and bust cycles; it only reacts to them. It’s also hard to control the spending behavior of millions of Americans all at once.
What Individuals Can Do
Our financial habits DO have an impact on our economy. One of the best ways to maintain a stable economy is when one lives within one’s means. This means not borrowing more than one can actually repay. If we are to avoid a true boom and bust the next time around, individuals must learn to relate differently to credit. Income is one’s greatest asset, not credit. While many people depend on credit for big purchases, they must also learn to maintain their income at a rate that does not place an undue burden on them when the bank comes calling.
So yes, I understand why the Federal Reserve decided to raise interest rates last month in order to combat inflation. If history is to be our teacher, it would not be farfetched to say that we are most likely heading toward another recession. The question is, what’s the best way to avoid a recession? Is it by raising and dropping interest rates as the Fed does or by allowing the free market to self-correct itself as Trump suggests? I’m afraid I don’t have specific answers, but I do tend to lean toward the latter opinion.
See other posts in this series:
Economics Series Part 1: Why Taxing Amazon Would Be Bad For All Of Us
Economics Series Part 2: Companies Brace For Impact Ahead Of U.K’s Brexit
Why Am I Writing About Economics in a Leadership Blog?
– Led by the Book