Finance

Why The Fed Doesn’t Just Keep The Benchmark Interest Rate Low To Grow The Economy

Because nobody likes inflation, stupid.

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On November 28, Jerome “Jay” Powell, the Federal Reserve’s chairman, delivered a speech at the Economic Club of New York. As part of those remarks, he stated that the Fed’s benchmark interest rate was “just below” neutral.

That wording is credited with propelling stocks atmospherically higher. Stocks soared by at least 2.3 percent overall on the 28th. The Dow Jones closed up by more than 600 points.

Conversely, in a PBS interview in early October, Powell said that rates were “a long way” from neutral. That phrasing had been blamed by some, including the president, for the stock market’s dismal October performance.

“I’m not happy with the Fed,” President Trump told a Washington Post reporter in late November, before Powell’s remarks on the 28th. “So far, I’m not even a little bit happy with my selection of Jay.” By Monday, however, the president seemed to have gotten a little bit happier, as Treasury Secretary and shaved hedgehog Steve Mnuchin told CNBC that Trump was “pleased” with Jay’s November 28th remarks.

Does the president have a point here? If the Fed can create wealth in the stock market by keeping the benchmark interest rate at historic lows, should it?

When dealing with anything as massively unwieldly as the U.S. economy, there are no easy answers, and there are always a lot of tradeoffs. I’ll try to strip this down into an oversimplification of a massively complex process. The central bankers at the Fed normally respond to weaker economic growth by slashing interest rates. This acts as a stimulus to the economy by making it easier for people to borrow money, to use that money to engage in economic activity, and to therefore grow the economy overall. But the more of something that is around, generally the less it is worth, and the same is thought to be true of money. If people are too easily able to borrow money, there is too much of it circulating, which devalues it, because now more money is available without a corresponding increase in production and service. Now you can buy less stuff than you could before with the same amount of money — that’s currency inflation. So, the other thing the Fed uses its interest rate lever for is to counter higher inflation. When inflation is too high, the Fed typically raises interest rates, thereby lessening borrowing and spending, increasing saving at the more attractive interest rates, lowering the amount of money circulating in the market, slowing the economy, and decreasing inflation.

One major problem, of course, is that inflation in a general sense just means stuff becoming more expensive. Your buck today gets you less than your buck did yesterday. And there can be a lot of reasons for that, including a too-low benchmark interest rate from the Fed, but also a lot of other things. Tariffs, for example, are just import taxes that increase the price of imported goods to the end consumer. Tariffs can lead to price inflation, which has the same basic effect on consumers as currency inflation: your buck buys you less of a given thing.

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With the benchmark interest rate low and the economy roaring at full steam, stocks may be up due to the overall economic growth, and there may be more jobs available for people, but the money people are earning from those stocks and those jobs is going to eventually be worth less to them in terms of purchasing power because of increasing inflation if the benchmark interest rate stays low. It is also worth noting that the scenario of both high stock prices and high inflation is weighted to favor the economically advantaged. It has been widely reported that around half of Americans have no exposure at all to the stock market. These folks still need to buy bread and eggs and gas and other things subject to inflationary pressures, but unlike the stock-laden among us, they are receiving no direct benefit from a roaring stock market.

Whether there are benefits or detriments to the Fed keeping the benchmark interest rate low depends on who you are and what you are trying to achieve. If you are trying to achieve good optics, well, remember that the stock market is literally measured in “points.” If you want to be able to say you got the most points, it helps to have an easy-to-understand scoreboard. On the other hand, it is a more nuanced argument to make that you have improved the lived experience of the average American by making sure the amount of stuff they can purchase with a dollar has stayed relatively stable over time. There’s not an up-to-the-minute scoreboard for that flashing by at the bottom of the screen on every cable news network.

So, if you find yourself saying, “Well, a booming economy is good for everyone, maybe we should just keep the interest rates low,” also ask yourself whether you would have liked to need a $50 bill to pay for a Pepsi in 2015 like Marty McFly in Back to the Future Part II. Fortunately, though, the Fed seems to know what it’s doing. Jerome Powell actually appears to have been a good choice to lead the Fed. He knows what his job is, and he has shown tremendous resistance to external pressures. His language isn’t always perfect, but for someone who can apparently move the stock market somewhere close to one percentage point per word spoken, I’d say he’s been pretty cautious. I’m a little bit happy with Trump’s selection of Jay, even if the man himself is not.

Jonathan Wolf is a litigation associate at a midsize, full-service Minnesota firm. He also teaches as an adjunct writing professor at Mitchell Hamline School of Law, has written for a wide variety of publications, and makes it both his business and his pleasure to be financially and scientifically literate. Any views he expresses are probably pure gold, but are nonetheless solely his own and should not be attributed to any organization with which he is affiliated. He wouldn’t want to share the credit anyway. He can be reached at jon_wolf@hotmail.com.

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