This March the Federal Reserve (the Fed) raised interest rates for the third time since the financial crisis. The benchmark interest rate increased from 0.75 percent to 1.0 percent. This increase was due to key economic factors such as unemployment hitting 4.8 percent and a 2.5 percent increase in the Consumer Price Index (CPI, which measures inflation) back in February. 4.8 percent is generally agreed upon as “full employment,” where all factors of production, including the labor market, are being used at their most efficient capacity. It’s important to remember that this measurement of unemployment does not indicate if individuals are over or underemployed. In addition, this increase in inflation was primarily due to increases in the price of oil over the last year. The Fed faces many discrepancies, including rising consumer confidence, the type of employment and the possibility of economic expansion under President Trump, it’s important to understand why and how the Fed plays with interest rates. It’s also important to understand to some extent why the Fed even exists, considering that its monetary policies have led us into recessions before. The 1980 Volcker Recession for example was induced by the Chairman of the Federal Reserve, Paul Volcker, by raising the interest rate.
If you’ve studied American history, you may have noticed that during the 1800s the US economy experience quite a lot of “panics.” The Panic of 1819 caused bank failures in the US, as did the “Panics” of 1857, 1873, and 1893. Have you noticed a trend? Typically during one of these panics, as the economy went south people would begin to withdraw their money fairly quickly from the banks, causing problems when money was being used for loans. Naturally, if almost everyone tried to withdraw their money the bank would bust, as it would not have the reserves pay their clients. Other failures were due to the inability for borrowers to pay back loans when loans were called in by both state and commercial banks.
Obviously failing financial institutions are never a good thing. In 1913, under President Woodrow Wilson, the Federal Reserve was created, thereby establishing a central banking system to help stabilize the economy and prevent banking failures from reoccurring—although it would notably fail in 1929. In its 100 years of existence, the Fed has done a lot of interesting work (pun intended). In short, the Federal Reserve System is a quasi-government organization that consists of 12 regional banks across the US that then communicate with that region’s private banks. For the most part, commercial banks lend to one another, however, banks can borrow from the Fed.
The Fed is in charge of monetary policy, which basically means it changes the money supply and interest rates. The Fed toys with these instruments in order to help the economy expand during recessions and contract during times of expansion. In theory this helps to minimize the effects of the boom and bust of the economic cycle. In short, the Fed looks to make it easier to make money during recessions and tougher to during the peaks of expansions. But how does the Fed change the amount of interest paid on loans?
The Fed has three instruments for implementing monetary policy. Its first instrument is the discount rate. The discount rate is essentially the rate at which commercial banks can borrow from the Fed. When the discount rate is increased, this encourages banks to lend and borrow from one another. It makes borrowing from the Fed more expensive, effectively making the Fed a lender of last resort. Second, the Fed can increase the reserve requirement that commercial banks must hold. The reserve requirement essentially dictates the amount of cash in reserves the bank must have at all times. An increase in the reserve requirement causes a contraction, as banks have less money to lend out. This measure is to prevent the panics seen during the 1800s and during the Great Depression. Third, the Fed can alter the interest rate by changing the money supply. This is perhaps the most glamorous instrument that the Fed has, as it typically gets the most attention in the press.
Interestingly enough, the Fed doesn’t actually change the interest rate. The change in the interest rate is actually a result by the change in the money supply. So how does the Fed increase the money supply? While you might think that the Fed would just print more money, it actually doesn’t (that’s the job of the U.S. Mint). Instead, the Fed engages in something called open market operations (OMO). This is where the Fed purchases/sells U.S. government securities in the open market. To best explain this relationship, let’s look at the current time period as an example.
In March, the Fed concluded that the economy was nearing the peak of an expansion, opting to balance the economy by increasing the interest rate. To do this, the Fed looks to decrease the money supply by entering the market for U.S. securities. Here, the Fed exchanges U.S. securities for cash at the going market price. To lower the interest rate, the Fed will sell U.S. securities, the selling of the securities causes a selling pressure that decreases the price of the bond. Due to the inverse relationship between the price of the security and the interest rate paid on it, the interest rate increases as the bond price decreases. As a result, there is less cash in the system (as more people are holding U.S. securities in their portfolio than cash originally).
A higher interest rate means that it is more expensive to borrow money. From a GDP perspective, this decreases personal consumption by households and spending done by firms on new plant equipment. Households and firms are typically interest sensitive, therefore their spending is a function of the level of the interest rate. As a result, less money is borrowed and GDP contracts. Almost all industries do not benefit from rate hikes. Financial institutions that lend money typically benefit from rate hikes because the amount of interest they can charge on loans goes up.
The Federal Reserve System is a means of minimizing the extremes experienced by the economy. To the everyday person, monetary policy might seem helpful during downturns and hurtful during upturns. However in theory on the macroscale, monetary policy and the Fed help to prevent over-expansion of the economy past potential GDP. Though the validity of this assumption is contested, as some argue that expectations of a higher interest rate actually cause inflation, the very thing the Fed looks to prevent. Unfortunately, we won’t know if Yellen’s rate hikes are indeed beneficial until well into the future due to external lags in the policy’s implementation.