Housing and financial markets have collectively been holding their breath, awaiting decisions from the Federal Reserve on possible monetary policy changes. And the results are in. The Federal Open Market Committee, the Fed’s monetary policy arm, voted to reduce two key short-term interest rates at its most recent meeting. Is this a solution to the subprime market woes, and the swings and plunges that market prices have been taking alongside them?
For those who may be wondering why so much attention has been focused recently on the Federal Reserve and its interest rate pronouncements, there are a number of good reasons for the fuss. Here’s a little two-part primer.
First, as the Central Bank of the United States, the Federal Reserve is the banker for the U.S. Treasury. That means that the Fed buys and sells Treasury bonds and Treasury bills, etc., on behalf of the federal government. Treasury debt represents loans made to the U.S. government by banks and other investors, and carries practically zero default risk. For a bank—balancing safety, liquidity, and earnings—Treasury securities are attractive assets, albeit ones that generally provide a lower rate of return in comparison to other loans, including consumer (credit card) debt and mortgage loans. But banks are sure that Treasury debt will be repayed, not necesarily so with their mortgage, consumer and commercial loans.
One of the Fed’s primary responsibilities is to make adjustments in the nation’s money supply. This means that the Fed has the authority and the ability to ease or tighten the amount of credit available to the nation’s banks. So while the Fed doesn’t directly control the interest rates that banks charge in most credit markets, and does not control mortgage interest rates, its policy decisions have wide-reaching effects. The Federal Open Market Committee’s decisions will ultimately generate changes in the highly sensitive capital and home mortgage markets. For both of these markets, even small interest rate changes can profoundly affect the total price of the capital project or the home.
How does the Fed do this?
The Fed’s monetary policy takes effect through the banking system. If the Fed wants to allow banks to lend more cheaply, it buys securities from banks’ Treasury holdings. Here’s the key to the credit-creation proces: the Fed has the authority and the ability to create cash. This cash is what it uses to make open market securities purchases. The Fed’s purchase draws down no balance anywhere in the economy; it is literally a thin-air creation. This cash is what monetary economists call ‘new money,’ ‘ base money,‘ or ‘high-powered money,’ because it becomes the basis of a stream of new credit and lending.
The interest rates that the Federal Reserve controls directly have similar credit-stimulating effects: the federal funds rate is the rate of interest that banks pay when they lend cash reserves, bank to bank, in the federal funds market. Lower rates equal more credit and thus more borrowing. The discount rate is what banks pay to borrow cash reserves directly from the Fed; likewise, a lower rate leads to more lending and borrowing. Both of these Fed-controlled interest rate changes are measured as a change in the U.S. money supply as well.
The most recent Federal Open Market Committee meeting minutes state that “Incoming information suggests that economic growth is slowing, reflecting the intensification of the housing correction and some softening in business and consumer spending. Moreover, strains in financial markets have increased in recent weeks. Today’s action, combined with the policy actions taken earlier, should help promote moderate growth over time.”
That’s what high-powered money is supposed to do, but there are caveats, including market bubbles, artificially low interest rates, and price distortions brought on by an ‘easy money’ policy. “The cumulative effects of the play-off between political advantage and economic necessity” are themes that are at this moment playing themselves out in the beleaguered housing and associated financial services marketplaces.
Monetary policy as a solution is extremely powerful, and its effects are economy-wide. But they are also sequential and uneven; not everyone benefits from the cheap credit once prices start adjusting upward. Some investments that look golden when credit is cheap are shown to be malinvestments—that need to be cleared out—once real market conditions return. And money prices function to inform us of the costs of our decisions, but if we distort money prices, we damage the ability to make good economic choices. This creates a variety of decision making problems for financial and real goods markets, and these topics are part of installment two of this discussion.
Next FMM: For Fed policy, does it matter if the problem is a Tiger by the Tail or an iceberg?