I think the Federal Reserve Bank(Fed) gets too much credit for the economy’s performance.
While the Fed does play a critical role in moderating economic swings, the real force in our economy is free-market capitalism. Our growth is driven by unparalleled innovation, entrepreneurship and work ethic – not Fed policy.
The Federal Reserve Bank is charged with ensuring full employment and stable inflation. It does so, in part, by making money more or less expensive, which translates into more or less access to credit. As the primary banker to America’s banks, the Fed exerts tremendous control over interest rates. Lower rates equal cheaper money, while higher rates result in more expensive money.
To hear the media and White House tell it, the Federal Reserve is the master puppeteer of the American economy. The Fed’s every scratch and hiccup is tracked obsessively in the news. And, our president is attacking the Fed on Twitter for not lowering interest rates low enough or fast enough.
If the Fed really were that powerful, it would mean the government-controlled all things business. This perception is both dangerous and erroneous.
The government’s role is to preserve the system we already have in place. They do this so Americans can prosper in the ways we do best. It’s extremely difficult, in my opinion, for a government to manufacture prosperity in a top-down approach for an extended period. A free-market capitalist economy seems to win out every time.
Think of our economic system as an F-150 or a Chevy Silverado. The frame, the wheels, the technology, everything you experience while driving is like the whole of our economic system. It’s powerful. Now, what makes the vehicle run are the engine and the fuel. That engine and fuel are the factors that rev American businesses; they’re our ability to keep moving forward.
By contrast, the Fed is either the brake or gas pedal. They are very cautious, like some Sunday drivers you see on the roads. They slow acceleration when they lower rates. And, when they’re light on the brake pedal, rates rise.
This week, they put their foot gently on the gas pedal and lowered rates by a quarter of one percent.
What does that mean, exactly? In essence, they lowered the ultra-short-term (or overnight) interest rate. It appears they are now targeting when it comes time for all the banks in America to lend to one another.
Hence, the Fed funds the “target rate.” The target rate is the interest rate charged by one financial institution on an overnight sale of balances at the Fed to another financial institution. The rate is determined by the Federal Open Market Committee (FOMC) arm of the Fed.
Banks are continually engaging in borrowing and lending to keep an optimal ratio of reserves to their demand deposits. Our banks must keep enough money on hand every day to ensure that when customers make withdraws – these on-demand deposits – the money is there. So, this target rate is an integral part of the whole banking system.
You may be thinking, “Wes, what’s the bottom line? How does this change impact me?” Great questions.
The impact on both you and the overall economy is two-fold. One, the Fed’s process to move this target rate either helps to inject money into the banking system or to draw out money (a.k.a. liquidity) in the banking system.
Two, it impacts the rates at which banks choose to lend to you. So, you can think of the Federal Funds Target Rate (FFTR) as affecting both the supply and cost of available loans. When the FED lowers the target rate, they are trying to make more money available with lower interest rate loans.
This entire process sets off a chain reaction that is meant to stimulate the economy – with more loans comes more economic activity. If you as a consumer can get a loan at a lower rate, then maybe you will buy that house or car, or invest in a particular business. In this way, the Fed’s chain reaction spurs on economic and financial activity.
The reverse is also true. When the Fed raises the FFTR, they are in effect drawing money out of the banking system. This action puts the brakes on loans by making them more expensive for individuals and companies to take on. Fewer loans equal fewer new projects, which then equals dampened economic activity.
As you can see, when the Fed moves rates, it creates a complex chain reaction to shift the cost and availability of money in our economy. When rates are up, the chain reaction means a loan you want to take out – or a current loan you have – can float, or adjust, to the prevailing interest rates. Think your credit card rate, your auto loan rate, and your mortgage rate on a new loan or floating loan.
The same is true for American businesses. This chain reaction affects a company’s rate for a line of credit or a bank loan. And ultimately, the interest rates at which companies can issue debt.
But remember where we started and we see the real bottom line: Our government is not the answer to economic growth, and neither is the FED. The answer lies in America’s business. This point is real, no matter if the Fed has its foot on the brake or the gas pedal. Not only are we innovative, entrepreneurial and hard at work, we are also resilient and continue to create our economic ability to thrive.
