Monetary Policy Dictates the Market, Yet Eludes the Public’s Understanding
The Federal Reserve is seemingly always in the news with talk of Janet Yellen, Chairwoman of the Federal Reserve, and the rest of the Federal Open Market Committee, or FOMC, (the decision making body of the Fed) raising interest rates. But most Americans don’t know how the Fed alters interest rates and what results from these changes.
Congress created the Federal Reserve in the Federal Reserve Act of 1913 with the principal goals of regulating the money supply and stabilizing inflation and thereby economy. The act was prefaced by a century of wild swings in economic fortunes and thousands of bank failures across the country. Until recently, to achieve these goals, the Fed had altered interest rates and bought and sold government bonds.
After the collapse of the financial sector in 2008, the Fed bought $3.8 trillion in government debt (bonds) to increase the money supply in an attempt to stimulate the economy. They believed that an upswing in consumer spending and investment would result from more money in circulation. Many so-called experts and economists alike feared that such an increase in the money supply would cause inflation to skyrocket and put us further into recession, but that has not been the case. In fact, this is the only year since the recession that inflation has approached the target rate of 2%. However, the increase in the money supply has not had the impact Fed officials hoped it would have; interest rates remain near zero but consumers and businesses have not been able to get loans at these low rates. Due to the lack in confidence financial institutions have in potential borrowers after the 2008 crisis, commercial banks are not issuing loans. This phenomenon is what economists call a “credit crunch.” From 2008 to 2014, loans issued by banks fell 26 percent while bank reserves held by the Fed increased by 26 percent. In effect, The Fed gave money to banks (by buying government bonds) but the banks, instead of loaning it out, gave it right back to the Fed in the form of cash reserves.
As the economy improves, the Fed aims to raise interest rates to prevent high inflation and stabilize the economy. However, after pumping so much money into the economy through buying government bonds, the Fed fears the removal of all this money from circulation.
This predicament has persuaded the Fed to enact a never before used policy, IOER (Interest on Excess Reserves). The IOER is the rate at which the Fed pays banks when they deposit more than the minimal requirement into the Federal Reserve. If the Fed raises this rate banks can raise their own interest rates creating a ripple effect across all financial institutions. This IOER policy has come under increasing scrutiny from Congress. They argue that high IOER rates only incentivize banks to leave reserves in the Fed and not loan out money.
Citing IOER policy as a reason why the Federal Reserve needs more supervision, some members of Congress have called for more legislative regulation over the Fed and operations. Further politicizing the Fed, however, would have massively negative side effects. It is possible for the economy to expand too much too quickly. Such a phenomenon occurs when inflation outpaces growth and the Fed must take steps to counter this, which often includes raising interest rates and decreasing the money supply. Both of these actions are against the interests of many big business and lobbying groups but are needed for the long-term health of the economy. In this respect, the Fed can end up looking like the villain when in fact the measures made by the FOMC are for the good of the country as a whole.
There are many misconceptions about the Federal Reserve circulating throughout our society. They corrupt the public’s view of an institution that serves as the great stabilizer for our economy. In reality, the Fed acts as the primary guardrail that keeps us from repeating the great economic panics of the 19th and early 20th centuries.
This article appears also in the Summer 2017 edition of The Arch Conservative in print.
— Matt Collins is a sophomore studying economics and Spanish. He is a regular contributor to The Arch Conservative.