The Possible Reciprocal Effects of the Federal Reserve’s Monetary Policy

In response to fears about an economic slowdown, on January 30, 2008 the Federal Reserve Bank announced it would again lower it’s targeted federal funds interest rate to 3%.
Though 3% is in no way the lowest interest rates have been in recent memory (this honor going to June of 2003 when rates were a mere 1%) the uniqueness of this decision stems from the speed at which interest rates have been repeatedly cut. Only eight days earlier the Fed had lowered interest rates from 4.25% to 3.5%. In the last six months alone the Fed has announced interest rate cuts five separate times, falling from 5.25% to it’s present 3%.
As the central bank of the United States, the Federal Reserve Banks actions have many important repercussions over the financial market directly and the economy as a whole more indirectly. These effects and subsequent counter-effects and counter-effects for the previous counter-effects can reverberate in and out, back and forth through every facet of the economy for many quarters, and must therefore be considered with the utmost seriousness.
By consistency lowering targeted interest rates the Fed is engaging in an expansionary monetary policy. This is carried out by firstly the Fed newly printed using raw dollars to buy up bonds on the open market thus pumping these dollars into the market and increasing the money supply. This mechanism works to lower interest rates since interest rates and money supply are inversely related. A relationship due to the fact that with a larger supply of money, banks theoretically have a larger stock of capital to loan out money. If this money stock is more than the demand for lending, interest rates, acting as the price for loanable funds, will fall.
At the same time, and in the same context, the Fed is lowering the federal funds rate, the rate that banks charge each other for overnight borrowing, and the discount rate, which is the rate the Fed charges banks to borrow from it. Accordingly the banks pass on the cost changes in these rates by adjusting their lending and borrow rates. This should again aid the economy by facilitating more lending by banks into the market, and via the expected multiplier effect, further increase the money supply.
In total in the three weeks between January 14 and February 4, 2008 the estimated money supply, or M1, rose by $36 billion. With these actions, the Fed now unleashes a slew of intentional and unintentional echo like effects.
In the short run, with an excess supply of money, we can expect regular citizens to increase their consumption in all goods, since with more money in their pockets they will be inclined to spend more of it. Yet if the increase in consumption, or aggregate demand, is not able to keep up with the increase of the quantity of money, or aggregate supply, then we can expect a rise in average prices, or relative fall in worth of our currency to occur. Inflation. When there is too many dollars, like any other good, worth of that good will decrease.
Admittedly, the Fed actions cannot be considered the sole source of any inflationary pressure. It may have many causes that can often be highly esoteric yet pervasive. As John Mayard Keynes once said, the process of inflation, “engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” Yet there is nothing more direct in cause and effect terms over inflation then total money supply, which the central bank has presumably total control over.
Since 1991, percent increase in the Consumer Price Index (I.E. inflation) has stayed relatively stable at in and around 3%. For 2007 the inflation rate suddenly jumped to 4.1% from 2.5% the year previously. Prices for many other essential goods increased even faster that year. The price of food rose 4.9%, the largest since 1990. And a fact that should require no figure to remind us, energy costs rose a significant 17.4% in one year.
For everyday citizens this can be devastating. One of the many apologist arguments for inflation is that nominal wages are suppose to keep up with any increase in prices. Sadly this assumption has not proven out empirically. Between 1964 and 2004 real average wages for Americans have in truth decreased by 8.3% after inflation.
As an additional side effect to any increase in the money supply, we can expect a depreciation of the Dollar’s exchange rate for the exact same reason that it will cause inflation. More of one commodity will decrease it’s value relative to other commodities. Additionally foreign investors will see the falling American interest rates and will expect a falling returns of sale to any savings investment that they may or might have in the American financial market. Both of these factors will lead to a drop in demand for U.S. Dollars and a fall in it’s price in exchange terms accordingly.
The U.S. dollar has been in a state of steady depreciation against all other major currencies (with the exception of the Japanese Yen) for the last few years. Between February of 2003 and the February of 2008 the Dollar has lost value against the Euro by 39 cents with 15 of those cents being lost in the last year alone. More closer to home, from January of 2003 to January of 2008 the U.S. Dollar has lost 53 cents against the Canadian Dollar.
Though we can assume that due to the lengths of these periods this trend is not directly the fault of any single Federal Reserve policy, it’s recent moves will no doubt aide to expedite any existing process as recent spikes in the exchange markets have shown.
There may be a silver lining to any depreciation in the U.S. dollar though. As a currency depreciates, goods and services from that country become a bargain on world trade markets. To cash in on those savings, foreign merchants will buy from that country, increasing that country’s exports. On the domestic end of the deal, foreign products will become more expensive for local buyers leading us to decrease the amount we currently import. The net effect will lead to an increase in the trade balance of payments.
This is good news, the United States has maintained for the last two decades a noticeable trade deficit. But this export/import gap has been seen to narrow in 2007 by $46.9 Billion from the year previously thanks presumably to increased exports and decreased imports.
Additionally this pressure should aid in stemming any further Dollar depreciation. As demand for our products, and thus our currency, increases, so does the price for those products and the value of the currency that the products are marked in. The exchange rate for the dollar should stop depreciating, possible even appreciate a little bit and obtain a new stabilized equilibrium.
The irony is that increasing exports can also be inflationary in itself, since foreign importers buy our exports with their own currency, this leads to more foreign currency in the hands of private citizens. This private foreign currency eventually has to be exchanged with banks, central and otherwise, for domestic Dollars. When this exchange takes place it pumps more Dollars into the market and thereby causing some inflation. In the long run each factor and counter-factor should counterbalance each other till all dynamics stabilize at a new market equilibrium. The United States economy is so huge and unimaginable complex that any rough shock that the Federal Reserve can create for good or ill will be easily be absorbed by one market component or another, given enough time. The issue at present is how long “in the long run” means, how long before our economy reaches again some point of constancy, and whether or not that point of constancy, that point of stability, that point of equilibrium will necessarily be to our every day general advantage, or are we going to be net worse off in the end.