THE FEDERAL RESERVE GOES ALL IN - WILL IT PAY OFF?
- Rohan Naval
- Jun 30, 2022
- 5 min read
Updated: Jul 14, 2022
The Federal Reserve (Fed), the official central bank for the US, is responsible for the operation of monetary policy. This consists of three main tools: interest rates, open-market operations, and reserve ratios. Interest rates refer to the amount of interest, or surplus money, that commercial banks must pay the central bank when borrowing money from it. Open-market operations, or bonds, are investments purchased between the Fed and corporations/commercial banks, which have interest on them and are repaid in bi-annual instalments. Reserve ratios are a percentage set by the Fed that state the amount of reserve cash that a bank must hold, relative to its deposits.
The tools outlined above are used to achieve a solitary goal — altering the money supply in the economy. If the money supply needs to be increased, the central bank will buy more bonds (either via using reserve currency or printing money) from commercial banks (which hold government bonds), decrease interest rates to make loans less expensive, and reduce the reserve ratios to increase the amount of money that commercial banks have at their disposal. The central bank can do the opposite to reduce the money supply in the economy. Of these three instruments, open-market operations are by far the most prevalent. The Fed maintains the right to mint money, and can, under a policy called Quantitative Easing (QE), buy bonds from commercial banks to increase the money supply. The Fed employs this strategy when directed by Congress to invest in certain corporations. For example, it minted a trillion dollar coin during the infamous bailouts following the 2008 recession that went to automobile companies such as GM, and $2.2 trillion during the Coronavirus Aid, Relief, and Economic Security (CARES) Act in 2020. Regardless of economic circumstances, or the state of the nation with respect to the business cycle, the root problem or a long-term issue with the Fed lies within this printing of money, which has led to the current inflation crisis. Regardless of politics and party affiliation, the recklessness seen with respect to minting currency has been a consistent trend.
<figure 1: Currency in Circulation>
As a result of having control over the money supply, the Federal Reserve looks towards controlling inflation, in addition to allowing the necessary cash flow for economic growth. Inflation is defined as a sustained rise in the price of normal goods and services over a period of time. The consensus amongst economists is that there are two types of inflation: cost-push inflation, which comes as a result of increased costs to firms, decreasing aggregate supply, and demand-pull inflation, occurring due to an increase in Aggregate Demand (AD). A general rule of macroeconomics is that the supply of money should increase at the same rate as the increase in goods and services. Most developed economies target a rate of inflation between one to three percent — this ensures that consumers spend in the short term, as prices will increase in the future, but also sees that money holds its value over time.
As stated above, QE was implemented in response to the COVID-19-induced recession to help stimulate Aggregate Demand (AD). This rapidly increased the amount of currency in circulation after 2020, which was increasing at a higher rate than ever seen before. This has had long-term effects, with economist Keaton Browder commenting that, according to the laws of supply and demand, an increase in the supply of money will decrease its value. This decrease in the value of money will mean that prices will have to be raised to make up for this lost value, hence leading to inflation. This phenomenon is also compounded by cost-push inflation or stagflation. Furthermore, due to the supply shock crisis and the impact of the Russia-Ukraine war on global trade, aggregate supply has also decreased, leading not only to negative economic growth, as seen in Q1 of 2022 but also contributing to increased inflation. As of June 2022, annualised consumer prices have increased by 6.6 percent, which most economists, including the Fed, view as one of the most significant current challenges in the US economy.
Despite debates over the causes of this inflation, the Fed has laid out a plan to counteract this increase. Jerome Powell, the Chairman of the Fed, has stated that interest rate hikes will be implemented and that they will “adjust the pace of hikes as needed”. Interest rates will increase by 2 percentage points over the course of 2022, including a planned increase of 75 base points (0.75 percent) in July, followed by 50 base points (0.5 percent) in September.
The economic effects of these interest rate hikes are already visible. Mortgage rates have increased from __ to 5 percent, echoing the increases seen in 2008, whilst consumer savings have decreased, as per the Q1 GDP Report. A brief explanation of how these lead to decreased inflation
These steps are what some would describe as a gamble, seeing how they are immense and drastic steps. Given that the Federal Reserve has already slashed GDP predictions from 2.8% to 1.7%, and that consumer spending was already decreasing as a result of inflation, some economists have stated that the effects of inflation are too high to ignore and that tackling inflation should be prioritised — even at the expense of economic growth, with Federal Reserve Governor Michelle W. Bowman admitting that the Federal Reserve’s actions “may present challenges for banks” in a speech on June 23. With such policies, the Federal Reserve is taking the stance that inflation is to be tackled at all costs. Although one would say that this is a rather cavalier attitude, it would be even more reckless to continue the previous inflationary policies of quantitative easing and printing money — it would not only be bad for the US Dollar, but also for the average consumer, who will have to struggle with an increasing cost of living. The Federal Reserve is headed in the right direction, with the right priorities. The economic policy of tapering- a periodic and gradual reduction in asset purchases (open-market operations)- was once discussed as an alternative to lowering interest rates. However, now the Federal Reserve could also look to decrease the money supply by decreasing the assets they purchase, which keeps a larger money supply with them.
Overall, the economic circumstances indicate that the Fed is headed with the right intention, but concerns arise as to whether such actions will lead to an economic downturn, as predicted by Deutsche Bank. Whilst short-term monetary policy may be in question, it is clear that the Federal Reserve and the US must reflect on the consequences of the unrestricted printing of money, and remember its impact on inflation and economic growth.
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