Recent finance headlines have fixated on instability in the banking sector, which has in large part been triggered by the Federal Reserve’s steady drumbeat of rising interest rates, in its attempt to reign in inflationary pressures on the US and global economy. The Federal Reserve, also known as the Fed, is the central bank of the United States. One of its primary tools for regulating the economy is the ability to raise or lower the federal funds rate, often referred to by its colloquial term, the interest rate.
Before the creation of the Fed, the United States had a decentralized banking system, where individual banks issued their own currency and were subject to few regulations. This system made it difficult to respond to financial crises, and there was no centralized authority that could provide liquidity to banks in times of need. As a result, the U.S. economy was vulnerable to financial panics, which could quickly spread and cause widespread economic disruption.
The Panic of 1873 was one of the most severe economic crises of the 19th century. It was triggered by the failure of a major investment bank and resulted in a six-year depression, with widespread bank failures and high levels of unemployment. Twenty years later, the Panic of 1893 was triggered by the failure of a large railroad company and resulted in a four-year depression. This crisis also led to the creation of the first national currency in the United States. Finally, in 1907, a run on banks resulted in widespread bank failures and liquidity shortages. The crisis was eventually resolved with the help of J.P. Morgan, who organized a group of bankers to provide emergency loans to troubled banks.
The Fed was created by the Federal Reserve Act of 1913, in response to these and other financial panics that had plagued the U.S. economy throughout the late 19th and early 20th centuries. The Fed’s main mandate is to promote maximum employment, stable prices, and moderate long-term interest rates.
To achieve these objectives, the Fed uses several tools, including open market operations, the discount rate, and reserve requirements. But perhaps the most powerful tool at its disposal is the ability to set the federal funds rate, which is the interest rate that banks charge each other for overnight loans. When the Fed raises the federal funds rate, it becomes more expensive for banks to borrow money from each other, which in turn makes it more expensive for them to lend money to their customers.
The Fed typically raises interest rates when it believes that the economy is growing too quickly, and inflation is becoming a concern. By raising interest rates, the Fed hopes to slow down economic growth and keep inflation in check.
When interest rates rise, it becomes more expensive for businesses and consumers to borrow money. This can lead to a slowdown in spending and investment, as businesses and consumers become more cautious about taking on debt. For example, a company that was planning to expand its operations may decide to delay those plans if the cost of borrowing money has increased.
Higher interest rates also tend to strengthen the value of the U.S. dollar relative to other currencies. This can make U.S. exports more expensive, which can hurt American companies that rely on international trade.
On the other hand, higher interest rates can also benefit savers and investors. When interest rates are low, it becomes more difficult to earn a decent return on investments like savings accounts, bonds, and CDs. But when interest rates rise, these types of investments become more attractive, as they offer higher returns.
Another way that higher interest rates can affect the economy is by increasing the cost of servicing debt. When interest rates rise, the cost of servicing existing debt also goes up. This can be a problem for individuals and businesses that have taken on a lot of debt, as they may find it more difficult to make their monthly payments.
It’s worth noting that the Fed’s ability to raise interest rates is not without its limits. If interest rates rise too quickly or too high, it can cause a recession by slowing down economic growth too much. For this reason, the Fed must balance its desire to keep inflation in check with its mandate to promote maximum employment.
In recent years, the Fed has kept interest rates at historically low levels in response to the COVID-19 pandemic. This has made it easier for individuals and businesses to borrow money and has helped to support economic growth. However, as the economy continues to recover, the Fed may begin to raise interest rates again in order to keep inflation under control.
Interest rates themselves do not directly cause inflation, but they can influence inflation by affecting borrowing costs, spending, and investment. When the interest rates are low, borrowing becomes cheaper, and people and businesses are more likely to take on debt. This can lead to increased spending and investment, which can, in turn, stimulate economic growth.
However, if the economy is already at or near full employment, increasing borrowing and spending can put upward pressure on prices, leading to inflation. This happens when the increased demand for goods and services cannot be met with a corresponding increase in supply. When this happens, businesses may raise their prices to take advantage of the increased demand.
Furthermore, low-interest rates can lead to inflation through their impact on asset prices. When borrowing costs are low, it becomes easier for investors to buy assets such as real estate, stocks, and bonds. As more people invest in these assets, their prices can rise, which can create wealth effects that encourage further spending and borrowing. This can lead to inflation if the increased demand for goods and services exceeds the economy’s capacity to produce them.
On the other hand, high-interest rates can help to control inflation by slowing down borrowing and spending. When interest rates are high, borrowing becomes more expensive, which can lead to a decrease in spending and investment. This can help to cool down the economy and prevent inflation from rising too rapidly.
It’s worth noting that the relationship between interest rates and inflation is not always straightforward. Other factors, such as changes in productivity, supply shocks, and expectations about future inflation, can also affect the rate of inflation.
The Fed’s job is to use its various tools, including interest rates, to balance these different factors and maintain price stability. The Fed must consider these risks and carefully calibrate its policies to ensure that it achieves its dual mandate of maximum employment and price stability, while also avoiding excessive risks to financial stability.
