Finance – The Federal Reserve and the Economy

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Money Matters

January 23, 2023 by Scott Crosby - Views: 67

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Finance – The Federal Reserve and the Economy

The Federal Reserve is the central banking authority of the United States.  Its role is to monitor the economy and to take actions to assure, as much as possible, a healthy economy, where people generally can live their lives confident that their financial standing is on solid ground.  

S490-1.jpgA healthy economy includes low inflation.  The Fed believes that everybody – the Federal government, businesses, and people generally – prefers an inflation rate of about 2%.  Its actions are therefore taken with that as a goal.

Money is a commodity like any other.  

If more money exists without a corresponding increase in goods, then necessarily money loses its value.  Each dollar will buy less.  Businesses and families become less able to buy the goods and services they would normally purchase.  Businesses lose income.  Businesses that are only marginally profitable cannot pay their bills, and must shut down.  Employees are laid off, and as a consequence they and their families can no longer buy the things they want and need.  Businesses that made those products fail as a result, and the process continues in a deadly spiral.  The economy – the well-being of businesses and families – suffers.

The only significant cause of country-wide inflation is when Congress and the President decide to spend more money than is taken in in taxes – “deficit spending”.  

Put another way, when Congress and the President unilaterally increase the amount of money, the result is that the same amount of money buys fewer goods.

To buy the same amount of goods, families and businesses must spend more money – inflation. 

It falls to the Fed to stop the inflation caused by Congress and the President – to compensate for that “extra” money.  

The Fed’s main tool to stop inflation is to increase interest rates.  Increasing interest rates effectively takes money out of circulation – i.e., acting like a “tax” that pays for all that Congressional spending.   Increasing interest rates makes it more expensive to borrow money, for everyone – businesses and families.

Of course, higher interest rates have a negative impact on businesses and families, just like inflation.  The goal is to slow down inflation; the danger, obviously, is not to raise interest rates so high that the economy slows down “too much”, creating a recession.  

The Fed must ride a thin line, slowing inflation but not sending the economy – and the well-being of businesses and families – into a tailspin.

When the Fed changes interest rates, the economy is very slow to react; it takes weeks and months.  So the Fed raises interest rates slowly – several times a year – and only a little each time, watching for signs of the impact, and hoping they have not gone too far.

Historically, the Fed has found that interest rates need to ultimately reach about 5% to counter-balance the deficit-spending by Congress and the President.  

With 5% interest rates, businesses find it difficult to grow and expand.  Families find it difficult to buy homes, goods, and services.  The country’s economy bogs down; the stock market seems stuck in a “bear market”, and gives no sign of an economic recovery.  This condition is sometimes called “stagflation”.  Growth is at a standstill; this is the “malaise” that President Jimmy Carter referred to in 1979.

Once inflation is slowed down, the Fed can then begin lowering interest rates, and the economy can begin to recover – unless Congress and the President continue their deficit-spending.  

Ironically, Congress will tout such spending as a “stimulus package”, as if it will help the economy.  Rather than admit that their over-spending was a mistake, Congress will vote to make conditions worse.  

Politicians meddling in the economy is the problem, not the solution.

Congress and President Carter caused the “malaise” in the 1970s.  The “malaise” ended when Jimmy Carter lost the 1980 election.  

The only possibility for change is to vote the current members of Congress and the President out of office, by voting instead for politicians who call for more fiscally-responsible attitudes.

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