Author's note 6/13/17: The Fed is raising interest rates yet again. I've said it before and I'll say it again, and the below analysis still holds true.
The news that the Federal Reserve is raising interest rates by a quarter of a percent is likely to inspire a variety of reactions, depending heavily on one’s political philosophy and one’s view of monetary policy.
Those on the Left are likely to want low interest rates to persist indefinitely, believing that such an environment will encourage borrowing and spending, and therefore stimulate the economy. Those on the Right will probably welcome higher interest rates as encouraging saving and being beneficial to investors.
Trump supporters will probably see the Fed’s actions as a partisan attempt to damage the president-elect, knowing that higher interest rates are usually accompanied by a short-term hit to the stock market. There is very probably some truth to this last accusation.
Rather than speculate on motivations, let’s take a step back and examine how the control of interest rates actually works and what the effects are. The chief function of the Federal Reserve is to regulate the quantity of money in the economy. While the media loves to talk about how the Fed controls interest rates, the bank can’t actually dictate the rates that banks offer. Instead, they influence these rates indirectly by either increasing or decreasing the amount of money in circulation.
Pumping more money into the economy tends to drive rates down, while less money tends to mean higher interest rates. This is an important insight because it shows that the Fed can’t actually keep interest rates near zero forever. There is a limit to how much they can increase the money supply without causing catastrophic rises in prices.
Many people think that increasing interest rates is bad for the economy, because stock market indices like the Dow Jones usually fall as interest rates rise. But the stock market is not the economy, only one piece of it. The reason the stock market does well with low interest rates is that investors seeking a return on their money have no other option than to buy stock — low interest rates make other investments unattractive.
Conversely, when interest rates rise, interest bearing accounts become comparatively more profitable, and people take money out of the stock market to reinvest in something safer. The decline in stock prices is not necessarily a signal of economic weakness, but merely reflects a reallocation of funds from one investment to another. In short, changing the money supply changes people’s behavior, or at least changes the incentives to which they respond.
Once you realize that the entire economy runs based on people responding to the right incentives, it’s easy to see how the process of centrally controlling the money supply can go very badly wrong. If the Fed sends the wrong signals, it can lead to massive amounts of money being invested in the wrong places. When those investments fail, the result is an economy-wide recession.
This is why most libertarians — with Ron Paul being the most prominent example — strongly oppose the Federal Reserve’s meddling in the economy. By holding interest rates down to artificially low levels for such a long period of time, the Fed encourages lots of borrowing, with the implication being that most Americans are saving their money to be spent later.
Otherwise, why would there be so much cash in bank vaults to be borrowed? But this assumption leads businesses into making bad decisions, because that savings doesn’t really exist, and people are in fact spending their money now rather than later. You can imagine the disaster that would befall a business planning for future spending that will never come. Now imagine that thousands of businesses are falling into the same error, all because of signals sent by the Federal Reserve, and you have a recipe for economic calamity. That brings us back to the original question.
Should the Fed raise interest rates? Short answer: Yes. They’ve been too low for far too long. Slightly longer answer: The Fed should get out of the business of deciding what the “right” interest rate is, and let market forces set rates instead. This is the only way we’ll avoid the painful consequences of misinformation, bad investments, and future recessions.
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