Econ 101: Is the Fed a Source of Our Economic Problems?

     Politicians and pundits are crying about the economy, from oil prices to housing and the U.S. dollar. But they rarely pause to consider how we arrived at our situation, as they call for more government help and often for the Federal Reserve to “do something.”

     Two Noble Laureates, Milton Friedman and Friedrich Hayek, have given us some insights into what effects the Federal Reserve’s actions have had on the economy.

     Friedman held that attempts by the Fed to stabilize the economy were likely to have, instead, a destabilizing effect. One of the reasons he put forth for this is that there are uncertain and probably lengthy lags between the time that the Federal Reserve realizes what is going on in the economy and the time its policy actions have an effect on the economy.

     The Fed is likely to increase business cycles as its policies take effect at the wrong time. It should concern itself with price stability and allow markets to self-correct. He also argued that the primary result of expansionary policy in the long run is inflation.

     Hayek was concerned not only that inflation would distort price signals in the economy as a whole and disrupt economic activity, but that Federal Reserve actions to affect interest rates give the wrong signal to producers about how many and what type of capital goods to produce.

How the Fed – and the Interest Rate – Works

     The Federal Reserve conducts monetary policy primarily through the buying and selling of bonds. When the Fed purchases bonds it increases the reserves of banks, thus adding to the ability of the banking system to expand credit and increasing the supply of money.

     The opposite occurs when the Fed sells bonds—banks give up reserves resulting in a decrease in the money supply. These actions affect interest rates, with short term rates falling when the Fed buys bonds and rising when the Fed sells bonds.

     Different eras of Federal Reserve leadership are dominated by different targets for monetary policy. The most recent era has primarily used targeting of interest rates, in particular the federal funds rate, which is the short term rate for banks to lend each other their deposits at the Federal Reserve.

     The Fed reduced the federal funds rate from 6.5 percent in 2001 to 1 percent by June of 2003 and held the rate there for a year. In a series of moves, the Fed then increased the federal funds rate. By June 2006, the rate had been increased to 5.25 percent. The Fed began lowering the rate again starting in November of 2007 until it had reached 2 percent by April of 2008, where it currently remains. This Federal Reserve policy resulted in changes in economic activity that are explained differently by different economic theorists.

     The real interest rate is based upon the willingness of consumers to forgo consumption goods today in order to get more consumption goods in the future (a.k.a. saving). Low interest rates are a signal to producers that they should produce more capital goods, such as machinery and buildings, that will result in higher production in the future.

     When the Fed manipulates the interest rate through monetary policy, it causes what Hayek called malinvestment. In particular, an artificially low interest rate will cause producers to produce too many – and the wrong type – of capital goods. This will lead to a slowing of economic growth and recession once the inflation that results from the expansive monetary policy takes hold, and once producers find that their production plans are not consistent with consumer demand.

     What might Friedman and Hayek tell us about our current situation?

    Inflation: First, Friedman would point out that the Federal Reserve maintained low interest rates through increasing the money supply. This increase in the supply of dollars will result in inflation – a rise in the general price level and a decline in the value of money. The several price indices used to measure inflation are showing increases. For example, the consumer price index has risen by more than 4 percent over the past year.

    The Dollar and Commodities: As the dollar loses value, people holding dollars will attempt to trade them for things which may rise in price faster than goods in general. The commodity price surge, seen in oil, steel, nickel and copper, is consistent with inflationary monetary policy. The increase in the supply of U.S. dollars relative to foreign currencies, such as the euro and the British pound, should result in a decline in the value of the dollar relative to these currencies. This is also what is occurring.

    Housing Market: The increase in the price of housing with expanded building and subsequent collapse of the housing market are consistent with Hayek’s view of artificially low interest rates affecting investment. By holding rates artificially low, the Fed stimulated a housing boom. Hayek would have called this malinvestment in housing construction. The housing boom collapsed once the fundamentals of the market took hold.

     There may be a number of factors explaining high oil and other commodity prices, a declining dollar, and a recession in the housing industry. But the work of the late Nobel Laureates Friedman and Hayek points to a monetary policy that kept interest rates artificially too low for too long. Their work should give us pause about using government to correct what are perceived as market failures, and to consider that what we are really observing is government failure.

Dr. Gary Wolfram is the William Simon Professor of Economics and Public Policy at Hillsdale College and a Business & Media Institute adviser.