by Fred E. Foldvary
The Federal Reserve system, America’s central bank, faces difficult choices. Past increases in the money supply are now pulling prices up, as monetary inflation creates price inflation. The mission of the Federal Reserve board is price stability, so they would like to prevent high inflation by decreasing the growth of the money supply. But with real estate topping out, with sales and construction falling, and housing prices level or falling, the economy is vulnerable to a recession. If banks have less money to loan out, interest rates will rise, investment will drop, and the economy will plunge into a recession.
The problem is that the Fed’s policy tool is blunt and clumsy. The Federal Reserve system’s main method of controlling the money supply is by buying U.S. treasury bonds. With its “open market operations,” the Fed buys bonds from the public through brokers.
Suppose the Fed buys a $1000 bond from you. It pays you with a check, which you deposit into your bank account. Your bank deposits that check into its account at the Federal Reserve Bank of the district it is located in. The Fed covers the check not by drawing money from some other account as with non-Fed checks, but by increasing the money reserves of your bank. This increase in the bank’s money reserves is the creation of money out of nothing by the Federal Reserve.
The Fed increases the money supply by an amount that keeps one particular interest rate on target. That interest rate has a funny name, the “federal funds rate.” This is the interest rate that banks pay when they borrow funds from other banks. The money the banks hold at the federal reserve banks are called “federal funds,” although the funds belong to the banks.
Banks are required to keep some ratio of reserves to deposits, funds which may not be loaned out. The rest of their funds, the excess reserves, can be loaned out. If a bank’s reserves falls below the required reserve amount, it must borrow funds to bring its reserves up to the required ratio. It usually does so by borrowing funds from banks that have excess reserves.
The interest rate on such federal funds borrowing is set by the market for those loans, but the Fed can alter that interest rate by changing the amount of excess reserves the banks hold, when it buys and sells bonds. If the Fed wants to lower the federal funds interest rate, it buys bonds, which increases the banks’ reserves, which lowers the federal funds interest rate as banks seek to loan out the extra funds.
The Federal Open Market Committee periodically sets a target for the federal funds rate, and then the Fed buys and sells bonds to manipulate this interest rate to stay at that target. The federal funds rate then has a big influence on the interest rates that the banks set when they loan out their funds to individuals and firms.
There main problem in setting the target for the federal funds rate is that there is no scientific way to know what the optimal rate should be. The optimal rate is the rate that would be set by a pure free market. There is a market for loanable funds, funds available to loan to borrowers. In a truly free market, the supply of funds comes from savings, and the demand comes from borrowers, and the rate is set at the rate at which the quantity of funds supplied equals the quantity demanded.
The free-market interest rate (or family of various rates) plays an important role in the economy, as it also determines the amount of goods that go to households for consumption and the amount that goes to economic investments, i.e. an increase in the stock of capital goods such as machines, buildings, and inventory. If savings go up, there is less consumption, and interest rates fall to increase investment, and all is well.
But if interest rates fall not because of more savings, but because of money creation by the Fed, the interest rate cannot do its job correctly. There is more investment, but folks are not decreasing their planned consumption. Prices rise, some prices more than others, and the economy becomes distorted and turbulent. People look to the Fed to cure inflation, when it has caused it in the first place.
The problem is not just inflation, but a waste of resources cause by investments and speculations such as in real estate, induced by artificially low interest rates that later get choked off when interest rates rise to stop the inflation. That is what is happening now. Past money inflation helped fuel a boom but is now causing more price inflation, but if the Fed reduces the money supply growth and raises interest rates, it reduces investment, which then reduces demand for other goods, and then the economy falls.
When output falls, we get a bear market of falling asset prices. The stock market plunges, real estate prices cave in, and rising unemployment depresses wages. But if the fed tries to prevent the recession by lowering interest rates, it can only do this by increasing the growth of the money supply, which creates even more inflation.
This is the dilemma that the Fed now faces. But regardless of what the Fed does, the distortions caused by its past policy and indeed by the very existence of money manipulation will inevitably cause a recession. The real estate boom has already peaked out and it has already created bad investments and speculative excesses. Funds already loaned out are already going bad, with defaults by borrowers facing rising costs of adjustable mortgage rates.
Watch out, because the bear is coming out of the woods. The bear will devour us with falling stock markets, folks losing their homes, loans in default, business shut downs, and job losses. The Fed is playing Goldilocks, trying to fine-tune the economy to balance inflation and recession, to have an economy that is not too cold or too hot, but in the Goldilocks story, when the bears returned, she ran away. The bears are coming home, but in the real world, there is no where to run. The bears will have us for dinner.
This article first appeared in the Progress Report, www.progress.org. Reprinted with permission.
Dr. Fred Foldvary teaches economics at Santa Clara University and is the author of several books: The Soul of Liberty, Public Goods and Private Communities, and the Dictionary of Free-Market Economics.