There seems to be a lot of discussion these days about the Federal Reserve’s role in managing interest rates. From a free trade perspective, interest rates should take care of themselves, going up or down based on market dynamics. But, as this column has repeatedly stated, world trade today is impacted by countries whose trade practices are anything but free-trade-based. It is a point of fact that most world powers set the interest rate their citizens—and other countries—have to pay to borrow money from them. But for the most part they do so in response to downward economic pressure and not to boost an already healthy economy. Countries like China excessively manipulate their interest rates in an attempt to gain an unfair competitive advantage. The question, then, is “how active should our federal government be in managing its interest rates?”
How does this all relate to supply chains, you may ask? Well, like it or not, supply chains today typically rely on healthy worldwide trade – not just the health of a single country’s economy. If a government sets policies that negatively influence economies worldwide, consumers, over the long run, will eventually have to “pay the piper” in the form of higher prices.
Access to money is essential to the health of an economy. The founding fathers – led by Alexander Hamilton – sought to facilitate such access by establishing the Federal Reserve Bank, which is comprised of 12 regional banks. The purpose of the Fed is to loan money to private banks at a national interest rate, as determined by its Board of Governors. When it reduces interest rates, the Fed must also print more money to support an anticipated increase in the demand for capital. To do so correctly requires balancing the easing of access to money against the risk of inflation. Why? Because if interest rates are kept too high, it hampers access to cash with the result that investment is reduced, dampening economic growth. On the other hand, if The Fed prints too much money, it de-values the dollar. In other words, pumping too much money into an economy usually ends up being a bad thing for consumers. I’ll relate an example of what can happen to an economy when a governmental body gets too involved in manipulating interest rates.
Back in the late 1970’s, I lived in Iowa. If you remember, at that time the economy was in recession due to a variety of factors including OPEC’s manipulation of oil prices by artificially limiting the amount of oil available to the worldwide market. As a result, credit dried up. The Fed failed to effectively maintain a proper balance between access to money and inflation. This contributed to inflation that led to higher interest rates.
Around that time I was looking to buy the ultimate consumer good, namely a house. At the same time in Iowa, a law was in effect that limited the maximum interest rate private banks could charge on home loans. The maximum rate was set at 9%. Because of the inflation that The Fed had contributed to market interest rates had been driven to over 10%. In Iowa—because of the cost of money to banks was now above 9%—there were NO home loans made statewide for several months, until the legislature could eliminate that law. The point that homes could not be financed during that period meant that new construction all but came to a halt which, to say the least, was not good for Iowa’s economy. It took the state a long time to recover from the effects of that law. Other states—ones that hadn’t tried to artificially manipulate their home loan interest rates—recovered from the recession more quickly.
And those of you who are old enough may recall that to help lift the country out of that recession—during the tenure of Paul Volker as head of The Fed—there was an almost immediate reversal in policy, limiting access money to reduce inflation.
The same phenomenon can happen with countries. The recovery period for those that print too much money in an attempt to prop up a troubled economy take longer to recover than those that are more conservative in their approach. Printing too much money only delays a softening economy and extends the time it takes to recover from it.
Over the course of our country’s history, some politicians have found it attractive to either delay economic downturns or to try to turbo-charge an economy that hasn’t yet slowed down. The overall negative impact of this type of governmental intervention demonstrates that political considerations should not be a basis for the Fed management of interest rates. Interest rates should be set by the directors of the Federal Reserve. They are typically seasoned economists and as such are the ones best suited for how to manage the nuances of an economy, not politicians. Along these same lines, politicians who try to rashly manipulate economies against market forces are, in effect, not being honest with their constituents.