Federal Reserve Interest Rates - 0910
* Types of Federal Reserve interventions in the economy
- Required Reserve Ratios
-> requiring banks to keep a certain % of deposits on reserve
-> since banks lend out deposits to make money, RRR limits how much banks can lend
=> the lower the RRR, the more the money supply grows and vice versa
-> RRR generally not adjusted, since it is difficult for banks to adjust quickly
-> 2008-2010 recession has raised questions about areas of the quasi-banking system
needed higher RRR
- Discount Rate
-> the Federal Reserve can directly lend to banks in need of cash
-> the interest rate for loans directly from the Fed is called the "discount rate"
-> the rate is generally above the Federal Reserve Rate that banks charge each other
=> keeps banking as private (non-gov) as possible
-> Federal Reserve serves as a panic-avoiding lender of last resort
=> banks can always get money
=> very important during the 2008-2010 recession
+> ultra-low rates effectively subsidized banks
-> Prime Rate (best rate of interest for rock-solid borrowers) floats over discount
- Open Market Operations
-> buying bonds injects money into economy
=> Fed buys bonds from banks, meaning banks exchange a security for cash
=> banks now have more money than they need for RRR, so they can lend
+> interest rate should go down since supply of loanable funds decreases
-> selling bonds pulls money out of the economy
=> Fed sells bonds to banks, meaning banks exchange cash for a security
+> since banks buy the bonds, the interest rate on government debt is market set
=> banks now have less money than they need for RRR, so they reduce lending
+> interest rate should go up as business compete for available loan funds
-> using open market operations, Fed can set the Federal Reserve Interest Rate
- Federal reserve also regulates some parts of banks and audits them
- in emergencies, Fed can do all manner of non-standard things
* Issues of the Federal Reserve Rate
- the Federal Reserve is reasonable disconnect from politics
-> long terms of appointees & private ownership insulate against government medling
-> Presidents would always want cheap money before elections if they could
- Federal Reserve has two goals
-> control inflation
-> maintain high employment and a healthy economy
-> these two are not always in harmony
- the Federal Reserve Rate is the quickest economic tool to change
-> if the economy is slowing, lower rates
=> more money, more borrowing, more jobs, etc.
-> if economy grows so fast the inflation becomes a threat, raise rates
=> less money, less borrowing, job growth stops or jobs lost, demand down, etc.
- stock market closely tracks interest rates
-> when rates rise, stock market tends to decline as businesses will have to pay more
for capital and will probably see reduced demand
-> declining (or rising) stock market can add to power of a rate change
=> people are immediately more or less wealthy
- raising the Fed rate does make government borrowing more expensive
-> another reason to insulate Fed from politics
- raising the Fed rate is the best way to crush inflation
-> a blunt tool, it can crush demand, borrowing, etc.
-> side effects are very untargeted
=> hard to raise or lower rates for individual industries or states
+> Michigan might need low rates while New York needs high ones
+> working class people lose jobs, even though they did nothing wrong
+> healthy business will take a hit despite however good and useful they are
-> because the effects are so broad and blunt, the Fed is often late in raising rates
=> miss the easy, low-imact moment to slow inflation
- Fed rate changes are quick to see, but slow to act
-> business make borrowing plans for year or more into the future
=> money borrowed now has to be contracted, allocated, put into practice
=> new factories, hiring, etc. can take years to fully ramp up
-> hard to know the right moment when economy is starting to overheat or contract
=> Fed tends to move cautiously or slowly as a result
=> poor Fed rate changes can make a bad situation much worse
+> Fed misreading of the Depression definitely made it worse
=> inflated dollars impossible effectively to uninflate
=> dollars destroyed in bankruptcy can't be resurrected
- Fed rates can't "push on a string"
-> lowering rates definitely stimulates the economy when decline is not too severe
-> during Depression or severe panic, businesses won't borrow for any reason
-> Lowering rates to zero (free money) might not even work
=> Why borrow money when one has no idea what will be happening in a year?