As FOMC meets, how fast is too fast for Federal Reserve to raise interest rates?

By: Pavel Mordasov

The US financial markets have recently experienced two milestones as the S&P 500 reached 3,000 on July 10^th and the Dow Jones Industrial Average (DJIA) crossed 27,000 the next day. The immense rise in the equity market is a remarkable feat from its lows following the mortgage crisis where the DJIA hit 6,507, and the S&P 500 fell to 676.53 on March 9, 2009, but Donald Trump has yet to be satisfied with this growth.

Jerome Powell’s Fed has abandoned the ultra-dovishness of the Yellen and Bernanke years. Under Powell’s control, the Fed has (slightly) raised the fed funds rate on multiple instances from 1.50% to the present rate of 2.50%.

Along with these rate hikes came a series of tweets by President Trump in which he attempts to sway the Federal Reserve into lowering interest rates so that, according to Trump, the U.S. economy can continue to grow. In a tweet last month, the President criticized the Federal Reserve for raising rates ‘far too fast’ and contracting the money supply even though its mission has been to unwind its looming balance sheet of $3.886 trillion that accumulated from the recession.

In response to these tweets, one is left wondering, “Mr. President, when does raising rates become ‘too fast’?” For nearly a decade since the mortgage crisis, the Federal Reserve pursued a policy of cheap money by keeping rates at historic lows of almost near zero. In addition, from 2008 to 2015, the Federal Reserve ran multiple rounds of quantitative easing which is an economist’s theatrical way of describing printing money to help prop up failed Wall Street banks by purchasing distressed assets causing their balance sheet to balloon from $900 billion to over $4.5 trillion.  Although the increase in the interest rates may be a significant increase from 1.50% to 2.50% (66%) the size of the swing it pales in comparison when we look at the information on Figure 1.1 and how interest rates almost reached historical lows of practically 0% for nearly a decade.

Figure 1.1 – Federal Funds Rate from July 10, 2006 to July 15, 2019. [7] (Macrotrends)

With the upcoming Fed meeting at the end of July, President Trump preemptively tweeted another critique to the Federal Reserve for raising rates ‘too fast’ and contracting the money supply again. However, the Presidents present tweets contradict his previous statements during the presidential debates of 2016 in criticizing prior chairman of the Federal Reserve, Janet Yellen for keeping interest rates too low and labeling the U.S. economy as a bubble cautioning the American public for a high possibility of a crash.

Is the lowering of interest rates in the best interest of the American public or preferably in the best interest of the President to artificially bolster financial assets and make assets appear more valuable on paper before reelection time comes? Although in the short-term, lowering rates may provide additional stimulus; however, it increasingly contributes to a process of mal-investment and misallocation of resources.

How the Fed Lowers Interest Rates

Banks today operate within a fractional-reserve banking system which means when a bank receives deposits its maintains only a fraction of those deposits in reserves and utilizes the other amount to be lent out to facilitate credit and make a profit on money that would otherwise stay idle. The interest rate that banks use to lend out money is determined by the supply of reserves available and the demand for credit. When banks accumulate an excess of reserves and to attract individuals to borrow, banks lower the rate of interest. When banks are short of reserves, and there is a demand for deposits, banks will raise interest rates to attract savings. However, in the event a bank is short on reserves to satisfy depositor demands, the central bank would step in, in this case, the Federal Reserve, and provide liquidity by printing money to help over-leveraged banks.

Throughout the establishment of the Federal Reserve, its role has changed over time to not only function as a lender of last resort but also to influence the supply of money and credit availability to ensure full employment and stable prices. One of the practices the Federal Reserve does to influence the economy is through the manipulation of interest rates by setting the federal funds rate. The federal funds rate is the interest that is charged to member banks for overnight loans. Commercial banks request these loans to meet the reserve requirement, which is the minimum amount of deposits that are required to be kept as a cash balance and not be lent out. If the Fed wants to slow the economy and contract the money supply, it will raise rates which condenses the available money banks have to lend out incentivizing individuals and firms to save. On the opposite end, if the Fed wants to expand the money supply and stimulate the economy, it will lower rates which gives banks more money to lend out which encourages individuals and firms to borrow and spend.

The Austrian Business Cycle Theory

When a central bank decides to embark on attempts to grow the economy, it manipulates the interest rate by lowering it. In doing so, the central bank prints money to buy commercial banks’ Treasury securities giving banks additional credit to lend out that was not supported by genuine savings from depositors. Thus, a decrease in interest rates encourages entrepreneurs to take out loans, which in effect fund business projects that otherwise would not have been deemed profitable before the artificial lowering of interest rates. If the Fed decides that there is a lot of business activity going on and consumer spending, it will begin to contract the money supply by raising rates and selling Treasuries to banks. A contractionary monetary policy will give rise to interest rates and increases in expenses for entrepreneurs. The increase in expenditure cost will cause many of these business ventures to become unprofitable and to those that had borrowed when rates were artificially low face a high severity in going out of business or having to lay off workers.

Is it Wise to Lower Interest Rates?

With U.S. markets having their longest-ever bull market coupled with home sales being a decline for the 16^thyear-on-year and manufacturing hitting an all-time low since 2009, the question that we must ask is would it be wise to revert to lower interest rates by stimulating the economy with cheap money?

Although the United States has gained tremendous growth in the financial markets and continues to dominate the international spectrum as the largest world reserve currency, additional rate cuts may undermine that position by creating an even more gigantic asset bubble.

This was originally published on Mises.org.