The Fed - Dr. Feelgood

August 23, 2006

Much of the volatility in the stock market in recent months relates to investors’ fears about the Federal Reserve’s decisions on short-term interest rates. Until very recently, the big questions were, ”When will The Fed stop raising rates? Will they overdo it and cause a recession? Will they fail in trying to stop the climbing inflation rate?”

On August 8th The Fed didn't raise rates, ending a campaign that started back in June 2004, yet some fear they are not done yet – while others worry that the damage was already done.

The Federal Reserve gets a lot of play in the financial press, but the reasons behind the fed raising and lowering interest rates are not clear to most people. We thought it was high time for a short primer on why the Fed does what it does.

Fear not – we’re not going to get into the complex mechanisms of central banking. Suffice it to say that the Federal Reserve has the ability to cause money to be easy or hard to come by. Easy means low interest rates and plenty of it around for borrowers to get their hands on to build or grow businesses – or just to buy stuff. Hard monetary policy means higher interest rates that can make borrowing money more difficult.

While maximizing employment and creating general financial soundness remain important, nowadays the primary goal of the Fed is to stabilize prices – not necessarily to work toward low inflation, but rather to steady inflation. If the Fed had to choose between a steady 4% a year inflation rate (prices of goods and services on average climb each year by 4%) or a rate that goes from 1% one year, to 5% the next, to 2% the next, they would choose the steady 4%. People make business decisions based on future price levels – namely what interest rate to pay on borrowed money – and stability makes it easier to predict the future cost of money. Lenders will require less of a safety buffer if the future looks stable, making money easier to come by for borrowers.

Officially, the Federal Reserve does not try to buy us out of recessions (that’s the job of the White House…) or to change policy to prick asset bubbles (irrational exuberance in the Nasdaq circa 1999). In reality the Federal Reserve is obsessed with recessions and asset bubbles because general economic activity and wealth are big drivers of how much borrowing goes on in an economy, and how much spending takes place. If we all woke up tomorrow and the stock market (or housing prices) had doubled, we would probably save less and spend more because our wealth, on paper at least, had increased. All that spending would cause the prices of goods and services to climb with the increased demand.

So what if things overheat? Why not just let the economy and asset prices move along with the free market? Why should the Fed try to cool down the economy (as they did toward the very end of the late 1990s boom) or stimulate borrowing and economic expansion during recessions (like they did shortly after the stock market and eventually the economy both took a dive a few years ago)? There are famous economists who advocate a hands-off approach to central banking.

Simply put, the Fed doesn't trust people to always do the right thing with their money. The government thinks if the economy takes a dive, business people and investors will eventually panic and cut back on spending and investing, creating a snowball effect that will eventually lead to another Great Depression. Nobody will want to lend or borrow, confidence in the economy will hit rock bottom, as one company lays off staff, other companies will have to follow as their customers are now unemployed with no disposable income.

The Fed makes borrowing essentially free, and discourages playing it too safe with your investments. How can you leave your money in a money market fund paying just 1% when a corporate bond pays 5%? The Fed is prodding you to use your money to keep the economy humming. The Fed is punishing you if you panic and play it too safe.

On the flipside the Fed thinks we become as crazed and irrational as children left in a candy store with no adults when the good times get a little too good. We live high on the hog and shift our investment strategy from sensible, moderate-risk diversification to outright speculation – looking to get in on all the action. Without the watchful eye of the Fed, we’d create an economic and asset house of cards that would collapse without warning.

The Japan asset bubble and resulting multi-year deflation and economic stagnation – even with near 0% interest rates – is the likely precedent for much current Fed thinking here, just like our own Great Depression is a big reason Fed policy has been overly careful about buying us out of a recession before it gets too bad.

The Fed thinks consumers, business leaders, and investors are all manic depressive and need Fed-dosed lithium to moderate the mood swings – or we’ll destroy ourselves in the unbridled euphoria and depression. The millions of people driving the economy and stock market need the detached brilliance of a handful of experts – who often can’t agree with each other on what policy mix is needed, or even where the economy or prices are going.

In truth, somewhere between the two extremes of a managed economy and a let-it-all-hang-out economy is what is called for. People are irrational, but a small number of economists don't necessarily make correct decisions either.

Worse, it’s possible the big dips and gains we don’t see in the economy because of the Fed would teach us restraint. Anyone who lived through the depression is wary of risk and speculation. Today’s generation is quick to speculate on homes with high-risk mortgage products or emerging market stocks or commodities – just a few years after one stock bubble nearly caused a major problem in the economy. Maybe the Fed stopped a big wipeout with their 1% interest rates prescription, but maybe that wipeout would have stopped future speculation better than the Fed ever could.