The Federal Reserve: a primer

The Federal Reserve has now met for September and as expected has lowered the base rate in the US banking system, known as the federal fund rate.

This is the first Federal funds rate decrease since the spring of 2020, the start of the Covid crisis. The Fed cut the rate to zero back then to juice the economy. By the time that crisis was deemed to have passed, nearly two years later, inflation was the new crisis. Thus, the Fed recently gave us a round of inflation busting rate increases followed by a frustrating period of holding-them-steady. And now at last a decrease by half a percentage point, or "50 basis points" as monetary economists prefer to say.

You, my reader, may have encountered discussions about the Fed funds rate many times over your years as a "news consumer". But it is possible no one has explained its significance to you before. Consider this your lucky day. I will italicize the next seven 'graphs. You'll see why.

In general, the ups and downs of interest rates in the rest of the economy (for your credit cards, for home mortgages, auto loans, triple-A corporate bonds) all roughly correlate to the fed funds rate. The adverb "roughly" in that a sentence is an important one, but over time the Fed gets what it wants. Eventually all those rates go up when the Fed wants and down when it wants.

Why does it ever WANT either? The Fed has two goals under statute: stable prices on the one hand and full employment on the other. The relevant contrary of stable prices is inflation, and in 2020-21 inflation was ignited by all the stimulus money thrown into the economy by the Fed and the fiscal policies of two administrations during the worst of the pandemic.

Why were higher interest rates the solution? Because they slow down the velocity of money, thus improving the stability of prices. Consider that if the prevailing rates for auto loans deter you from buying a new car, you make do with the old one for another year. That means your money is slower to burn its hole in your pocket and any upward pressure there might have been on the price of cars is reduced on demand/supply grounds.

By the same token, lower rates should lead to a faster velocity of money and an increase of economic activity -- they did so even during a pandemic period with lockdowns all about.

So, to review: through 2020-21 the Fed, responding to Covid, kept rates on the floor. Through 2022-23 the Fed, fearing inflation, raised rates. Late in 2023 it halted that rise, but for months into 2024 it declined to start any lowering.

The Fed, though, sees itself as Goldilocks. If interest rates had stayed too high for too long they would have depressed demand to an extent destructive of production and, thus, jobs. Had the interest rates stayed high, then, we might soon have gone from overly hot economic porridge to overly cold porridge.

This first rate cut in the cycle won't be the last. But the big question is: did it come in time? Or was the fed funds rate too high for too long, in which case we may get what is loosely called a "hard landing" (a phrase that sounds just a little nicer than 'crash'.)

What I have just provided you is a very conventional view of monetary policy, central bank decision making, etc., as that conventional view applies to events of 2020-2024. Much might be -- much HAS BEEN -- said and written against the conventional view. Google the phrase "Phillips curve" and you can go down the rabbit hole of related controversies. Some will tell you that the italicized account is nonsensical.

Personally, I believe there is some truth to the paragraphs I have just written. But I italicized them precisely because, in certain important contexts, that can be a very misleading truth.

At any rate, the italicized paragraphs, which describe recent events in the framework offered us by the late A.W. Phillips (1914-1975), will give you an idea of what those of us in the business of covering financial news mean when we talk about the ups and downs of the federal funds rate. If such discussions had been Greek to you before, they may seem like English to you now.

The photo above is of Phillips posing with a very high-tech (circa 1951) piece of equipment, the "Monetary National Income Analogue Computer" or MoNIAC.

A Story About Coleridge

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Jamesian Philosophy Refreshed

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