The View From 1776

How Interest Rate Manipulation Punishes Us

Why is it bad for the Fed to reduce interest rates when, as now, the dollar is falling against other currencies?

The Fed doesn’t just issue an order for rates to come down.  It has to pump artificially created money into the financial system to reduce interest rates.

Interest rates are the price for money.  The relationship is easier to see with ordinary goods and services.  If a bumper crop of apples hits the market, the price of apples will fall.  In the same way, if the supply of money increases, interest rates (the price of money) will tend to fall.

There is, however, a real limit to the effectiveness of the process, as we learned painfully in the 1970s stagflation.  Up to that point, faith in Keynesian economic orthodoxy (the standard doctrine of the Democratic party) assured us that increased government spending is the cure for any recession.

To implement decisions of the Federal Reserve Board to reduce interest rates, the open market desk of the New York Federal Reserve Bank creates money with bookkeeping entries and buys Treasury securities from financial institutions.  The result is a net addition to the money supply, which ordinarily will result in lower interest rates and an increased readiness of financial institutions to make more loans.

Such an increase in the money supply precedes any increase in production of goods and services.  The result is to create an overall inflationary push throughout the economy.  More money available to buy the unchanged supply of goods means that prices for goods and services will be bid upwards.

Artificially increased deposits in banks’ hands abets speculative lending, as we saw in the 1990s boom-and-bust and in the recent collapse of the overbought housing market.

Artificial expansion of our money supply enables us to consume more than we are producing.  Increases in consumer credit, via credit cards and home equity loans, creates an illusion of prosperity that adds fuel to the inflationary fire, driving upwards prices of goods and services.  Foreign exporters such as Japan and China meet the increased demand here with cheaper merchandise manufactured overseas. 

An additional result is loss of jobs here, because our inflated costs make us uncompetitive with those exports from foreign nations.

As our imports grow, the supply of dollars in the hands of central banks in exporting nations balloons beyond our ability to recycle those dollars via offsetting exports of goods that we produce. 

As it becomes more apparent to the rest of the world that the United States cannot redeem those central bank dollar holdings, foreign exchange traders bid the dollar down against other major currencies.  Central banks have already begun to redeploy some of their dollar holdings into other assets and other currencies.  Oil producing countries and others have begun to demand payment for our imports in currencies other than dollars.

The ultimate negative thrust is that, while the Federal Reserve attempts Keynesian   efforts to boost the economy with lower interest rates, foreign central banks demand higher interest rates on the U.S. Treasury securities in which most of their dollar holdings are invested in order to compensate for the declining purchasing power of the dollars they hold.  Domestically, institutional investors look down the road and foresee that interest and principal repayments on bonds, five to thirty years from now, will be worth much less in purchasing power, because of inflation.  The rise of interest rates begins to accelerate.

Thus, from both overseas and here at home, pressure mounts for increasingly high interest rates.  As interest rates rise, business profits are squeezed and incentives for increased production are reduced.  More plants lay off workers and we fall into economic recession.

The result is stagflation of the sort that scourged the nation under President Johnson’s Great Society, the last great Democratic party, liberal-progressive money expansion.

Be prepared for a rerun if a Democrat is elected to the presidency this November.  The recessionary impact will be compounded by higher taxes on businesses and upon the wealthy whose savings are essential to finance business capital investment that expands production and jobs.

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