​The Federal Reserve and Interest Rates

By Johnathan Li ’24

The Federal Reserve (The Fed), the central bank of the United States, defines “maximum employment, stable prices, and moderate long-term interest rates in the U.S. economy” as its primary goals for conducting monetary policies, as mandated by the U.S. Congress. Employment provides households with income, and a stable price level offers agents in the economy greater control of the future, including how they may manage their spending or saving behaviors. Both these objectives have corresponding quantitative parameters, the former being the “natural rate of unemployment,” when unemployment in the economy is minimized and limited only to those frictionally or structurally unemployed, and the latter being the inflation rate. It is argued, most famously by economist John Maynard Keynes, that an economy is better off with a moderate degree of inflation, as to stimulate spending — for savers would receive less return in an inflationary economy — and thereby economic growth; the rate that is the target for the Fed is 2 percent. These two goals, maximizing employment and stabilizing price levels, can often contradict each other, especially under the context of recent policies by the Federal Reserve to combat inflation.

On March 16, 2022, the Fed issued an FOMC (Federal Open Market Committee) statement declaring the implementation of monetary policies in reaction to persistent and elevated inflation, aggravated by demand-pull inflation and supply scarcity caused by the pandemic, when the federal funds rate was approximately zero. The statement explained that “to achieve maximum employment and inflation at the rate of 2 percent over the long run … the Committee decided to raise the target range for the federal funds rate to 0.25 to 0.5 percent and anticipates that ongoing increases in the target range will be appropriate.” The federal funds rate is the interest rate at which depository institutions (i.e., savings and loans associations, commercial, and savings banks) lend surplus reserves to other depository institutions to fulfill reserve requirements, with the target for federal funds rate being established by FOMC.

Since the Fed cannot directly set the federal funds rate between banks, it has to utilize Open Market Operations (OMOs) to adjust the rate to the target level; in OMOs, the Fed purchases or sells illiquid securities to regional banks to adjust the reserve balances of those banks. Increasing the federal funds rate by selling securities via OMOs would decrease investment and consumption as banks become more conservative in lending since it becomes expensive to borrow from other banks to reach reserve requirements (for more details regarding fractional reserve banking, see Mr. Blanton’s article in the same issue). Both OMOs themselves and the resulting increase in the federal funds rate reduce the money supply in the economy and subsequently cause an increase in interest rates throughout the economy.
           
The most recent FOMC meeting on March 22, 2023, however, also had to address the collapse of the Silicon Valley Bank and Signature Bank on March 10 and March 12, respectively. Continuing the sustained efforts to alleviate inflation, the Committee raised the target range for federal funds rate by 0.25 percentage points, the ninth consecutive interest rate hike starting from March 2022; this increase brought the target range to 4.75 to 5 percent from the 4.5 to 4.75 percent of the last FOMC statement on Feb. 1.

Nonetheless, it has come into question whether or not the Fed should continue increasing rates: “We believe, however, that events in the banking system over the past two weeks are likely to result in tighter credit conditions for households and businesses,” stated Jerome H. Powell, the Chair of the Board of Governors, “... As a result, we no longer state that we anticipate that ongoing rate increases will be appropriate to quell inflation.” Banks have become more modest in lending following the bank crisis, which leads to criticisms that the Fed’s decision to increase interest rates is redundant and runs the risk of causing a significant recession — “hard landing” — and therefore a rise in unemployment. Hence, the Fed faces a predicament. On one side, it needs to stabilize price levels to ensure economic stability and the purchasing power of the currency, and on the other, it faces a tightening financial condition intensified by two successive bank failures: its two duties in conflict.

Students of economics can recognize this trade-off from the Phillips Curve, graphing (in the short-run) the inverse relationship between inflation rates and unemployment. The next Federal Open Market Committee meeting will conclude May 3; depending on its results, it will be known whether or not the Federal Reserve can navigate its long-term inflation-reducing plans through the economic and political dangers of further raising interest rates amidst banking instability.