The Significance of the Fed Pause: Interest Rates, the Economy and Inflation

After 17 straight quarter point rate hikes going back to June 2004 the Fed paused on Tuesday leaving the federal funds rate at 5.25% (from 1% back in June of 2004).  In this post I want to try and explain why they did this and why this is important.

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Interest rates are a crucial determinant of economic activity.  Consider someone thinking about taking out a loan to expand his business.  One of the most important considerations is the rate of interest he’ll have to pay on the loan.  If he has to pay 2% he’ll be alot more likely to take that loan than if he has to pay 10%.  Same for someone considering whether or not to buy a home.  Low interest rates stimulate economic activity and growth; high interest rates constrain economic activity and choke growth. 

Why then, you might be wondering, would the Federal Reserve ever raise rates?  Economic growth is a good thing so why not just keep growth low and let the party rage?  One word: Inflation. 

The reason the Federal Reserve can control interest rates is because they control the supply of money.  They lower the rate of interest by expanding the money supply.  An increased supply of money in the banking system with the same demand for mortgages and business loans lowers the price of money i.e. the interest rate. 

However, by expanding the supply of money, they reduce its value.

This is simple supply and demand.  Imagine that all of a sudden the number of apples for sale in the United States doubled.  All of a sudden farmers and grocery stores have all these apples that they need to unload.  What do they do?  They lower the price to the point where people are willing to buy all those extra apples. 

Now imagine that the supply of all goods and services stays the same but the money supply doubles.  All of a sudden banks and individuals have all this extra money.  What do they do?  They start bidding up the price of goods and services and lowering the price of money (the interest rate) for mortgages and business loans.  The result is that each unit of the money can buy less goods and services and command less interest from borrowers. 

This is inflation.  Inflation is bad because it causes a rise in prices and undermines people’s confidence in the money. 

Money is crucial to the smooth functioning of an economy as a medium of exchange.  Without money people would have to exchange doctor visits for groceries, computers for gas etc….  Money is what makes trade on wide scale possible.  Trade on a wide scale is what makes possible the division of labor and specializition that are the cause of greatly increased productivity. 

So you don’t want to mess around too much with the money.  You want people to be confident exchanging their labor for money and that their money will generally buy a certain amount of the goods and services they ordinarily consume. 

The Fed continually faces a tradeoff between economic growth and inflation. 

There is alot of political pressure for economic growth.  People want to see their incomes and the values of their stocks and homes go up.  Presidents and politicians want to see GDP (Gross Domestic Product) increase under their watch and say that their policies are the cause of economic growth. 

The hard truth however is that the cause of economic growth is increasing productivity and innovation.  The growth caused by lowering the interest rate and increasing the money supply is artificial: incomes and asset values go up but the cost of living also goes up by the same amount getting us nowhere.  In fact, the lower interest rates distorts the decisions made by businesses and consumers leading to massive dislocation and ultimately a reduction in economic growth. 

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Back in 2000, the implosion of the NASDAQ, the technology heavy stock exchange, threatened to throw us into a recession.  There was a general loss of confidence in the economy and a resulting slowdown in lending and economic activity.  In order to prevent us from going into a recession, then Fed Chairman Alan Greenspan slashed interest rates dramatically.  He cut them all the way down to 1% in 2003 where they stayed until the current rate raising cycle began in June 2004.

Cutting interest rates staved off a recession and promoted “economic growth” primarily in the form of a massive housing bubble.  With interest rates on mortgages at extremely low levels people started buying homes.  This increased demand for homes started pushing up their prices.  Over the last few years more and more people started piling in, driving housing prices up to ridiculous levels and making a great part of the population (homeowners) feel increasingly wealthy. 

This “wealth effect” made them feel comfortable spending money on all kinds of things: vacations, eating out, new clothes, cars, etc….  After all, with their homes rising $50,000 a year, they could afford it.  In addition, many of them tapped the equity in their homes through home equity loans giving them cash to spend. 

This increased spending, founded on housing, buoyed the rest of the economy: retailers, electronic equipment makers, tourism, etc….

The problem, of course, is that all this increased “wealth” was really founded on an increasing money supply which made possible such low mortgage interest rates.  Unbeknownst to most people the housing boom and the economic boom built on it were paid for by the destruction of the value in the dollar – the dollar has tanked dramatically in contrast to other currencies in the last few years. 

Which is why the Fed started to raise rates in June of 2004.  At that point, they felt comfortable that they had rescued the economy from recession but began to worry about the price that might have to be paid in terms of inflation. 

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Now, with the Fed pause on Tuesday, the Fed has again swung to the other side and is worrying that by raising rates to stem inflation they are going to choke off economic growth. 

Housing stands on the edge of a major precipice.  Inventories are up all over the country. Have you noticed all those “For Sale” signs everywhere?  Sales volumes are down.  Orders for new homes have tanked and most publicly traded homebuilders have seen their share values cut in half in the last year.  Many people are facing adjustable rate mortgagtes that are adjusting up and interest only mortgages that are soon going to require them to pay principal as well as interest. 

If housing tanks, the “wealth effect” and the home equity loans that have spurred consumer spending and stimulated the rest of the economy will disappear.  In fact, if housing tanks, people not only won’t feel increasingly wealthy, but increasingly poor.  And as their homes values fall, they won’t be able to tap the inreasing equity in their homes because it won’t be increasing.  Restaurants, retailers and service industries will see their revenues decline, their stock prices will fall in line with their earnings, they will stop their growth plans and possibly lay off workers causing even more problems for the economy. 

As Greg Ip wrote yesterday in his wonderful front page Wall Street Journal article, “Fed Pause Aims to Balance Risks Facing Economy” (subscription required):

Fed officials acknowledge that a key risk to their forecast is that the housing market could fall harder than they expect, with ripple effects on consumer confidence, spending and investment [bold and italics added].  Avoiding such a low probability, high cost event may have been a motivation for pausing.

How “low probability” such a scenario is is debatable:

Nouriel Roubini, an economist at New York University and author of a popular economics blog, said it is already too late.  ‘The Fed should have tightened earlier to avoid a festering of the housing bubble early on.  The Fed is facing a nightmare now: the recession will come and easing will not prevent it.’

In other words, what Ben Bernanke and the rest of the central bankers on the Federal Open Market Committee are thinking in deciding to pause is something along the lines of: “Okay, so hopefully by raising rates and cutting back on the growth in the money supply over the last couple of years we have avoided the destruction of the dollar and a massive inflation which would destroy the United States and the world economy.  In the process, however, we’ve pushed housing to a dangerous precipice that could cause a recession.  So let’s go the other way now, stop raising rates, and hopefully get a ‘soft landing’ economically.  Everybody cross your fingers.”

People have different views about how this is all going to play out but the one thing that is for sure is that we are entering a fragile point in the business cycle:

The Fed is entering what has traditionally been one of the most delicate phases of the business cycle [bold and italics added].  The economy has reached full strength and inflationary pressures have built.  There are signs that higher interest rates are slowing the economy, but it remains unclear if they have slowed it enough – or too much.  The Fed paused at a similar point in February 1995 and in May 2000.  The first time, the economy had a ‘soft landing’ – slow growth followed by five more years of expansion.  The second time, it fell into recession.