Mises Daily Articles
Why the Fed Should Not Lower Rates
For the time being, the Fed’s decision makers have decided to keep the federal funds rate target unchanged at 1.75 percent. They hinted, however, that if the economy were to slow further, they would lower the rate.
Some commentators have protested that the Fed should not lower rates because doing so will dilute the strength of this tool in "fighting" a future economic slump. A rate of 1 percent leaves little wiggle room.
But this criticism misses the point. The main trouble with further reductions is that this would further intensify the already unsustainable pattern of consumer consumption and thereby make the current economic slump much more severe. Let us understand why this is so.
How loose money and credit affects the pattern of consumption
The key to the expansion in real wealth is saving--which is an unconsumed production of goods. Thus, if a baker produces 10 loaves of bread and consumes one loaf, his saving is nine loaves of bread. He can now exchange his saving for a pair of shoes with a shoemaker. Observe that his savings are his real means of payments--he pays for the shoes with the saved bread. Likewise, the shoemaker pays for the nine loaves of bread with the shoes that are his real savings.
What gives rise to real demand for goods is the production and saving of goods; the demand for goods is always fully backed up by a corresponding production of goods. Obviously, as the production of goods expands, it gives rise to greater demand for them. For instance, the baker may decide to exchange his saved bread to enhance his production facilities, which in turn will enable him to lift the production of bread. This, in turn, will give him greater purchasing power, since he can acquire a greater variety of goods with more bread at his disposal.
The introduction of money does not alter the basic fact that the driving force of real wealth expansion is real saving. All that money does through its role as the medium of exchange is to facilitate the flow of real wealth among various wealth producers.
When a baker sells his bread for $1 to a shoemaker, he has supplied the shoemaker with his saved (i.e., unconsumed) bread. The supplied bread will sustain the shoemaker and allow him to continue making shoes. Note that money received by the baker is fully supported by his unconsumed production. As the medium of exchange, money will enable the baker to secure goods and services some time in the future when he requires them. In other words, money is the baker's claim on real savings--it is not, however, savings.
Through money, people channel real savings, and this permits economic activity to take place. Thus, the goods that are exchanged for money by one individual support the production of another individual, who then, by exchanging his produce for money, supports a third individual. In this way, money enables real savings to permeate across the economy and lift the pace of production of goods and services.
Once real savings are exchanged for money, it is of no consequence what the holder of the money does with it. Whether he uses it immediately in exchange for other goods or puts it under the mattress, it will not alter the fact that his real savings are already employed toward the expansion of real wealth. Furthermore, if the holder of money decides to buy another financial claim, such as a stock, he simply transfers his claim on real savings to the seller of the stock.
In a free, unhampered market economy, there will be a harmonious and sustained change in the pattern of consumption with a rise in consumers’ real wealth. This harmony, however, gets disrupted when the central bank pumps money via an artificial lowering of interest rates. The monetary pumping disrupts the production of consumer goods because when money is injected, not everybody gets it first.
The injection of new money into the economy benefits individuals who receive the newly created money first ,at the expense of those individuals who don’t receive the new money at all, or who receive it late. The early recipients can now purchase a greater amount of goods while the prices of these goods are still unaffected. In other words, the early recipients' real wealth has increased. According to Rothbard, "The individuals who receive the new money first are the greatest gainers from the increased money; those who receive it last are the greatest losers."1
As prices of various goods and services start to rise, this hurts those individuals who don’t receive the newly printed money at all--or who receive it last. Note that, while, in an unhampered market economy, demand for goods is exercised through the production of goods, now the central bank money out of thin air permits consumption without production. What we now have is pure consumption of real wealth. The newly created money gives rise to the diversion of real wealth toward the early recipients of money at the expense of other individuals.
Because the early recipients of money are much wealthier now than before the monetary injections took place, they are likely to alter their patterns of consumption. With greater wealth at their disposal, their demand for less essential goods and services expands. The increase in real wealth of the first recipients of money gives rise to the demand for goods which, prior to monetary expansion, would not have been considered.
In contrast to this, the late recipients of money, or those who don’t receive the newly printed money at all, have less real funding at their disposal. This undermines their demand for the various essential goods required to sustain their lives and well-being.
How changes in the pattern of consumption alter the pattern of production
A change in the pattern of consumption draws the attention of entrepreneurs who, in order to secure profits, adjust their structure of production in accordance with this new development. According to Mises, "In the capitalist system of society's economic organization the entrepreneurs determine the course of production. In the performance of this function they are unconditionally and totally subject to the sovereignty of the buying public, the consumers."2
In the process of mobilizing funding to accommodate the consumers’ altered pattern of consumption, businessmen also rely on bank loans. As a result of the loose monetary policy of the central bank, commercial banks lower their lending interest rates, thereby making borrowing by businessmen more attractive. The expansion in bank credit, in turn, further lifts the money supply rate of growth and further boosts the relative demand for nonessential consumer goods. As the monetary pumping continues, this eats into real savings and starts to hurt various wealth-generating activities. This subsequently sets in motion the dynamics of an economic recession.
When money "out of thin air" gives rise to consumption that is not supported by production, it lowers the amount of funding that supports the production of goods and services of the first wealth producer. This, in turn, undermines his production of goods, thereby weakening his effective demand for the goods of another wealth producer. The other producer is then forced to curtail his production of goods, thereby weakening his effective demand for the goods of a third wealth producer.
In this way, money that is created out of thin air destroys savings and sets up the dynamics for the consequent shrinkage of the production flow. (The money out of thin air destroys the real purchasing power by destroying savings. Remember, means of payments are real savings.)
In response to the resulting decline in economic activity, banks curtail their loans to businesses, thus putting pressure on the money supply rate of growth. This further weakens the demand for various nonessential consumer goods and, in turn, weakens the viability of various businesses engaged in the production of these goods.
As a rule, a recession emerges once the central bank reverses its loose monetary stance. However, as was shown above, the inflationary boom always plants the seeds of a recession--implying that even if the central bank were to decide not to alter its easy stance, the depletion of the pool of real savings would put an end to the artificial boom.
Explaining historical data
Since 1959, there have been eight phases of low-interest-rate policy:
|1.||1959.11 to 1961.9|
|2.||1966.11 to 1967.7|
|3.||1969.8 to 1972.2|
|4.||1974.7 to 1977.1|
|5.||1981.6 to 1983.2|
|6.||1984.8 to 1986.10|
|7.||1989.3 to 1993.12|
|8.||2000.7 to now|
The following chart provides the confirmation of these low-interest-rate phases. The shaded area represents the low interest rate phases.
Historically, as we can see, the tendency for the relative overproduction of durable goods versus nondurable goods takes place, not immediately, but with a lag. It must be appreciated that a shift from a tighter monetary policy to a looser one doesn’t produce instantaneous effects; it takes some time. The time lag results because it takes time for the money to move from one receiver to another.
However, once a low-interest-rate policy begins to dominate the scene--i.e., it outweighs the effect of the previous tight stance--there is the tendency for the relative growth momentum of durable goods production versus nondurable goods production to increase.
Likewise, the dominance of the low-interest-rate phase doesn’t disappear instantaneously with the introduction of a tighter interest-rate stance. Obviously, there are some other factors that exert their influence on the data and thereby cause the effect of loose monetary policy on the pattern of consumption to be less pronounced in some phases versus other phases.
The relative increase in consumer durable goods production versus nondurable goods sets in motion--after a time lag--an expansion in capital goods production. Inspection of the chart below indicates that the increase in the growth momentum of business equipment production relative to nondurable consumer goods production tends to occur at the latest phases of loose monetary policy.
The relative growth momentum of durable consumer goods production tends to lead the relative growth momentum of business equipment production by about eight months. The current loose monetary policy has significantly lifted the relative growth momentum of durable goods versus nondurable goods, and this raises the likelihood of a strong increase in the relative growth momentum of business equipment in the months ahead, all other things remaining equal.
In short, loose monetary policy prevents the necessary adjustment, thereby raising the likelihood of a much more severe economic slump ahead.
The main problem with lowering the rate is not that the Fed may lose a tool to fight a recession; the trouble is that lowering interest rates will make things much worse. Low-interest-rate policy intensifies the relative overproduction of durable goods against nondurable goods, which subsequently slows down the adjustment in the capital goods sectors. All this, in turn, is likely to set in motion a much more painful economic adjustment in the months ahead.