This past Tuesday was one of those days when we who teach economics just have to drop down on our knees and give thanks.
The Federal Reserve Open Market Committee met promptly at 9:00 a.m. By 1:30 that afternoon the Fed issued a press release stating that the Committee had approved action to lower short-term interest rates. And then interest rates increased.
What is that you say? You listened to the news and heard that the Fed had cut interest rates. Moreover, some major banks had lowered their prime rates, the interest rates they charge their most credit-worthy business customers. Furthermore, you know that some consumer interest rates, including those on many credit cards, are tied to these prime rates. So what is this stuff about interest rates rising?
What most people failed to note is that while some short-term interest rates reportedly dropped, those for longer-term loans and bonds actually rose. Interest rates on 30-year Treasury bonds rose to 5.9 percent, the highest in several months and up 30 basis points since the beginning of the year.
Few people in the general public or general media have noticed that the interest rates on 30-year fixed-rate home mortgages have also risen by nearly a half percentage point in the 130 days since the Fed began increasing the money supply more rapidly.
That is why yesterday was a blessing to economics teachers. There are interest rates, and then there are interest rates. The Fed funds rate is not the prime rate is not the T-Bill rate is not the 30-year mortgage rate is not the rate on new auto loans. Moreover, the Fed does not set interest rates. It controls the money supply, which in turn influences interest rates.
When econ teachers try to make that distinction to their students, most yawn. A few note it down. But if they came to the course knowing any economics, it includes the well-disseminated fact that “the Fed sets interests rates.” All of this increasing and decreasing the money supply mumbo jumbo is just a technicality.
But every once in a while, like last Tuesday, the Fed takes action that lowers some interest rates, such as the Fed Funds and prime rates, but raises others, such as those for 30-year bonds and fixed-rate home mortgages.
In any class, there is usually at least one student who is either buying a home or refinancing one. When you tell these individuals that Federal Reserve action to spur the economy will increase their monthly payment on their mortgage, their howls of anguish and outrage are usually loud enough to rouse even the most somnolent students in the back row.
So why has four months of aggressive “rate cutting” by the Fed increased the monthly payment on a 30-year, $125,000 mortgage by $30? Because people in capital markets know that to cut short-term interest rates by 2.5 percentage points in 20 weeks, the Fed has to crank out considerably more new money. Creating new money, if taken too far, usually increases inflation in the longer run.
Banks making short-term business loans at the prime rate don’t have to worry about that. So the prime can drop. But people with money to lend long term, as in making home mortgages or by buying 30-year bonds, are much more vulnerable to inflation. When the Fed revs up its printing press, they instinctively pull back and will lend only if long-term rates rise enough to compensate them for the increased inflation risk.
Does the immediate reaction to Tuesday’s action mean that most U.S. citizens have to worry about roaring inflation, a la 1979? No, we are far from that. Except for energy costs, prices are pretty docile.
But this week’s events should serve as a cautionary lesson to thoughtful Americans. Central banks can force down interest rates to stimulate flagging economies. However doing so is not risk-free.
Members of the FOMC have to walk a fine line right now. An excessively restrictive stance may brake an already slowing economy. But an excessively expansionary one could bring inflation and higher long-term borrowing costs for business and households. And there is no good economic model that reliably predicts what path the economy will take in the next six, 12 or 18 months. Making monetary policy isn’t an easy job, but someone has to do it.
© 2001 Edward Lotterman
Chanarambie Consulting, Inc.