A Federal Reserve Primer -- And Why You Don't Need To Worry About Interest Rates Today

A Federal Reserve Primer -- And Why You Don't Need To Worry About Interest Rates Today

And Why You Don't Need To Worry About Interest Rates Today | September 2016

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Last weekend the Federal Reserve Board’s leadership met to discuss the future of America’s monetary policy. Reports out of that meeting, like reports from all Fed meetings, are long, tedious, and pretty much say nothing. Every analyst tries to interpret from the Governor’s statements what might happen next. And because the Fed leadership is so vague, and so academic, the analysts inevitably never guess right.

This bothers a lot of people. There are those who want a lot more “transparency” from the Fed – meaning they want much clearer signals as to what is intended, and usually specifics as to intended actions and a timeline. Because the Fed’s meetings are so cloaked and opaque, some congress members actually want to do away with the Fed, or regulate it a lot more closely.

But for most of us, most of the time, the Fed is pretty much immaterial. When the Fed matters is when there are big swings in the economy, which happen quickly. Then their action is crucial.

Why Small Changes In Interest Rates Don’t Really Matter To Most Of Us

Take the debate right now over a quarter point rise in interest rates. How does this affect most people? Not much. If you have credit card debt, or a car loan, your interest rate is set by the financial institution.  And you may hear people talk about zero interest rates, but you know your rate is a whopping amount higher than that. And you know that a quarter point change in the Federal Funds rate will not affect the interest on those loans.

Where you’ll see a difference is in a mortgage. But here, is a quarter point really important?

When I graduated business school in 1982 and wanted to buy my first home the interest rate on an annual, variable rate loan was 18.5%. My first house cost just about $100,000 so the interest was $18,500 per year. Today, mortgages are around 3.5%, fixed for anywhere from three to seven years. $18,500 in interest now funds a $525,000 mortgage! If interest rates go to 3.75% – which has many analysts so concerned for the economy – the home value associated with interest of $18,500 drops to $500,000. Probably within the negotiating range of the buyer.

So you have to borrow a lot of money for this quarter point to matter. And it does matter to CEOs and CFOs of companies that lead corporations on the S&P 500, or those running huge REITs (Real Estate Investment Trusts) that have enormous debts. But that is not most of us. For most of us, that quarter point difference will not have any impact on our lives.

So Why Do People Pay So Much Attention To The Fed?

The Fed was originally created during barely 100 years ago (1913) to try and create a more stable monetary system. But this didn’t work too well in the beginning, which led to the Great Depression. And then, to make matters worse, the conservative bent of the Fed coupled with its fixation on stable interest rates led it to actually cut the money supply as the economy was tanking. This led to a collapse in the value of goods and services, particularly real estate, and the loss of millions of jobs greatly worsening the Great Depression.

It was the depression which really caused economists to focus on studying Fed actions and the economic repercussions. A group of economists, most notably Milton Friedman at the University of Chicago, started saying that the Fed shouldn’t focus on interest rates, but rather on the supply of money. These folks were called “monotarists” and they said interest rates should float, and economists should focus on stable prices.

The 1970s – “Easy Money” Inflation

As we moved into the 1970s, and as Fed Governors kept trying to control interest rates, they found themselves creating more and more money to keep rates low, and in return prices skyrocketed. “Easy money” as they called it allowed ratcheting upward incomes, big pay raises, higher prices for commodities and inflation. Another monetarist leader, Paul Volcker, was named head of the Fed. He rapidly moved to contract the money supply, allowing those 18.5% mortgage rates to develop. Yet, this did stabilize prices and eventually rates lowered, moving down constantly from 1980 to the near zero rates of today for Treasury Bonds and other very large, low risk borrowers.

When the Great Recession hit the Fed leadership, led by Ben Bernanke, remembered the lessons of the Great Depression. As they saw real estate values tumble they were aware of the domino effect this would have on bank failures, and then business failures, just as they had occurred in the 1930s. So they flooded the market with additional currency to keep failures to a minimum, and ease the real estate collapse.  This sent interest rates plummeting to the record low levels of the last few years.

Policy Must Address The Current Situation, Not Be Biased By Historical Memories

Yet, people keep worrying about inflation. Those who lived through the 1970s and saw the damage done by inflation are still fearful of it. So they scream loudly about their fear that the last 8 years of monetary ease will create massive future inflation. They want the Fed to be much tighter with money saying that all this cash will someday create inflation down the road. Their view of history is guiding their analysis. Their bias is a fear that “easy money” once caused a problem, so surely it will cause a problem again.

But economists who study prices keep saying that there are currently no signs of price escalation – that wages have not moved up appreciably in a decade, home values are barely where they were a decade ago. Commodity prices are not escalating, in fact many (like oil) are at historically low prices. The dollar is stronger because, relatively speaking, the U.S. economy is doing better than the rest of the developed world. As long as prices and wages remain without high gains, there is little reason to tighten money, and little reason to feel a higher interest rate is needed.

Further, current monetary increases will not cause future inflation, because monetary policy only affects what is happening now. “Easy money” today can only create inflation today, not in three years. And inflation is almost nowhere to be seen.

Ignore Fed “Fine Tuning.” Pay Attention When A Crisis Hits. Otherwise, It’s Up To The Politicians

The big thing to remember is that small changes in policy, such as those that might affect a quarter point change in rates, is “fine tuning” the money supply. And that has pretty nearly no affect on most of us. Where as citizens we should care about the Fed is when big changes happen. We don’t want mistakes like happened in the 1930s, because that hurt everyone. But we do want fast action to deal with a crisis like the falling real estate values and bank collapses that were happening a decade ago.

Remember, it was when the Fed targeted interest rates that the U.S. economy got into so much trouble. First in the Great Depression, and then in the inflationary 1970s. But when the Fed targeted prices, such as in the 1980s and the mid-2000s, it did exactly what it was created to do, maintain a stable money supply.

So don’t worry about whether analysts think interest rates are going to change a quarter point, or even a half point, in the next year. The big economic question facing us is not a Fed question, but rather “what will it take to increase investment so that we can create more jobs, and provide higher wages leading to a higher standard of living for everyone?” And that is not a question for the Fed to answer. That is up to the economic policy makers in the legislature and the White House.

 

This article was written by Adam Hartung from Forbes and was legally licensed through the NewsCred publisher network.

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