Over the course of the past several weeks, there have been numerous measures aimed at reviving the nation’s struggling economy. Most of these actions are still ongoing, and their success level will not be known for quite some time (although signs of modest progress are around). While several of them have been historic and even unprecedented, at least one has followed the same tack often taken when faced with economic difficulties – lowering interest rates!!
The Federal Reserve (Fed) was created in 1913 primarily to provide liquidity to the economy which was suffering from the results of the Panic of 1907. The central bank gradually morphed into a watchdog with special attention given to both inflation and availability of monies for normal business operations.
The Federal Reserve requires all banks and financial lending institutions to maintain a certain amount of cash (reserve balance) on deposit at their local Fed branch office. The Fed Funds rate is the percentage of interest banks are assessed for overnight loans of these reserve balances to one another. When you hear all of the fretting about the Fed raising or lowering rates, this is the rate being manipulated. This flow of money among banks is essential to the smooth functioning of the economy.
When the Fed raises the interest level, banks are often more hesitant to borrow money to keep their reserves at the required level. In addition, the rates they charge when they do make loans are directly related to the interest level established by the Fed. As rates go higher, loans are usually more costly and difficult to acquire. Therefore, businesses are less inclined to borrow and, thus, such action slows economic expansion. Raising interest rates is a tool to help cool the economy when signs of inflation begin to surface. It is generally pretty effective in that higher rates get people’s attention and can virtually force them to come into line. It is like pulling on a rope; you get some traction.
On the other hand, when the Fed drops rates, the idea is that banks open their coffers wider, businesses expand, and home loans are less expensive. Often during such times, homeowners take out home equity loans, using the money for purchases of goods or services, which in turn generates growth in the economy. This tool, therefore, is used when the goal is to stimulate the economy and speed the pace of economic growth. The problem is that, while this approach is sometimes effective, it can only encourage firms and consumers to borrow and spend: it cannot compel such actions. Lowering interest rates is more like pushing on a rope; it does not have the same clout as going the other way.
When the Fed drops the cost of money, it has the effect of making loans less expensive, but if companies aren’t borrowing or banks aren’t lending, the initial result may be negligible. The Fed can offer the incentive of lower rates, but sometimes it isn’t enough. If folks remain too concerned about the future to take on additional debt, lower interest rates won’t do much good. This situation, which seems to be a part of the current credit financial crisis, is what British economist John Maynard Keynes referred to as a “liquidity trap.”
To make matters worse, there’s also a signal problem. If analysts, who pour over every nuance of the Fed’s monthly announcements and listen to the tone of every speech of every member, believe the rate might fall before long, the market response begins almost immediately – never mind that it sometimes takes more than a year for the impact of the rate change to percolate through the entire economic system. Because of such a hint, there often is also a delay in making purchases in hopes that prices and loans might go lower in a short period.
To combat a possible recession in early 2001, the Fed began lowering interest rates. Three years later, to combat potential inflation, the central bank reversed course. By August 2006, the Fed stopped increasing rates because concerns about inflation were muted and signs of an economic slowdown were on the horizon.
A year or so later, as the credit crisis became more invasive, the Fed began to lower the Fed Funds rate from the high of 5.25% in efforts to increase liquidity to financial markets and improve confidence in the overall economy. Last month amidst the myriad efforts to pull the economy out of its funk and improve the credit markets, the Fed lowered the rate to 1%.
There is little doubt that the Fed’s actions help steer the economy’s course, but it is also evident that there’s only so much the Fed can do. While recent drops in interest rates are an important part of the process and will likely help to accelerate the expansion once it begins, they will not be sufficient to jump start business activity nor will they be the most significant facet of the various rescue efforts being implemented. As a result, the more exotic initiatives now being put into place must be a part of the process.