The Manila Times

An alternative to the Fed’s obsession?

EI SUN OH ➤Ei Sun OhA5

The Federal open market committee of the United States Federal Reserve System (America’s central bank, colloquially known as the Fed) acted again last week to raise the interest rate with which it extends short-term loan to major financial institutions, by 0.25 percent, causing the Fed rate to hover around 4.75 to 5 percent.

This round of the committee’s meeting was reported to have lasted a total of two working days, with Fed board members and regional Fed governors debating vigorously as to whether to raise the interest rate again and if so by how much. In the end they settled for a raise of a quarter of a percent.

The original intent of the Fed’s interest rate adjustment in order to attempt to regulate inflation was undoubtedly a most lofty one, and, at least according to past experience, might be said to have worked to a certain degree. Inflation could eat into the incomes and savings of the average consumers, as their ability to purchase goods and services is severely weakened. Even in our times, the runaway inflation, sometimes to the tune of hundreds or even thousands of percent, in some of the developing or even developed economies horrifies us. So the Fed’s inflation-combating intention was good, to never again subject Americans to the vagaries of inflation as they were during some stretches in the last century. The problem lies, however, with the socioeconomic “side effects” that are almost invariably engendered by the raising (and conversely lowering) of the Fed rate.

Just as with most other public policy, Fed rate adjustment has both its positive and negative consequences. As banks’ interest rates rise, consumers would be more willing to deposit their erstwhile disposable income in banks to enjoy the heightened interest rates. Consumers would thus have less money to spend in the open market for purchases. Macroeconomically, this implies that the demand for goods and services drops, or that demand becomes lower than supply. Prices would thus have to be dropped in order to make it more appeal

ing for consumers to rake in cheaper goods and services. As such, the Fed’s aim of bringing down previously high prices would be achievable. At least that is the principle.

But at the same time the interest rate with which banks lend to businesses would also become higher. Calculative businesspersons would balk at such a higher interest rate, as it would cut into their profit margins. If they find it not as profitable to take out such high-interest loans, they would, well, not take out such loans, or at least take out lower amounts of loans. Gone, at least temporarily, would also be the businessperson’s original proposal to expand their businesses with the loans.

This would bring about at least two interrelated negative socioeconomic effects. For one, the businesses which do not take out loans, or take out smaller amounts of loans, would therefore not produce, or produce less of, goods and services. The aggregate demand (which is impacted by lower or no spending) would then not be necessarily lower than the lowered aggregate supply. Instead, supply and demand would approach some point of intersection, and it is not impossible that demand may even surpass supply. If the latter were to happen, the motivation for businesses to lower their prices would dissipate, as they revert to previously higher price positions to take advantage of the comparatively higher demand. And the Fed’s aim of taming inflation would be soundly defeated. It is thus apparent that the Fed’s raising of the interest rate would lose its inflationfighting efficacy over time.

Another self-evident negative socioeconomic effect that the Fed’s interest hike brings about is often an eventually receding economy, as consumer spending drops and businesses are reluctant to expand. In other words, as the world’s largest economy continues to raise its interest rate, the present economic malaise suffered in the US and beyond would persist. Occasionally, some other previously not as noticeable side effects would also kick in.

The recent wave of bank runs as even major banks scramble to make their deposit and investment levels sustainable, sometimes causing them to close shop, testifies vividly to the deleterious effects of prolonged rate hikes.

But despite the internal debates, the Fed was determined to continue to raise its interest rate, in order to relentlessly bring the US inflation rate down to the 2-percent target which the Fed so loves. This 2-percent figure is frankly not a rigorous number endowed with special meaning in economics. It is at most a figure plucked from thin air by the Fed intent upon maintaining a low inflation rate, but not so low as to stifle business vibrancy, as businesses would understandably like to see some degree of price hikes in order for them to rake in ever higher profits. It was just a conventional figure used by the Fed, based on its observation of historical American socioeconomic development.

I have previously proposed that the Fed would be well advised to just as well try out some other methodology to measure the urgency of interest rate adjustment. The efficacy could even be more pronounced than the present obsessed 2-percent target, and the socioeconomic side effects may not be as strong. For example, when the difference between the interest rate and the inflation rate is less than 2 percent, then the Fed should stop adjusting its interest rate. In other words, instead of compulsively attempting to maintain a 2-percent inflation target, the Fed would adjust its interest rate only if its difference with the inflation rate is higher than 2 percent. If the Fed were to adopt this methodology, it would see that as the latest inflation rate is about 6 percent, while the current interest rate is around 5 percent, it is time to bring to a close the latest round of interest hikes, as the difference between the two rates is only about 1 percent. There is no magic formula for combating inflation, and one target is probably as good as the other. But at least the side effects should be minimized.





The Manila Times