The Fed has been ratcheting interest rates up for the last several months, ostensibly to fight back inflation. Given that only a portion of the price hikes now felt around the globe are currency related, given that fears of recession due to China’s covid lockdowns and the Russian invasion are rife, this seems like a sketchy course of action.
Large portions of the higher prices today are direct results of production shutdowns or slowdowns during the pandemic, “supply chain” issues that are only now starting to resolve. Raising interest rates won’t help increase oil production, or move products through ports quicker, or help trucking companies hire more drivers. Oil drillers today are short of workers, pipe, drilling components, and investment capital; more expensive money won’t help with any of that.
So why is the Fed making such aggressive moves on interest rates? History gives a strong clue to the other motives at play.
We are at the end of 15 years of low interest rates, with mortgages below 3% and an official zero interest rate policy (ZIRP) from the Fed since just after the Great Recession. The Fed’s official mission is to promote full employment and control inflation, and interest rates are one of the most potent of the weapons in the Fed’s arsenal.
You will read endless criticisms of ZIRP and the Quantitative Easing (QE) that the Fed has used since the Great Recession to drag the country out of the economic hole into which we fell in ’09. Few if any of these critics will mention what forced the Fed to reluctantly employ these tactics.
The Fed stated early and often in ’09 that the best national response to a cratering economy should come from Congress, mostly in the form of counter cyclic stimulus spending to fill that crater back up, to save businesses, jobs, mortgages threatened by foreclosure, to save families under dire economic threat through no fault of their own. The Republican response to this desperate request was “over our dead bodies”.
Republicans instead embarked on a course of relentless economic sabotage. They started on inauguration night in a meeting of current Minority Leader McCarthy, several Republican House and Senate members, and notorious back bench bomb thrower and former Speaker Newt Gingrich, to plot their strategy to sink the Obama administration.
Their “answer” to the horror of a Democratic super majority in both chambers of congress and possession of the Oval Office was to ditch the long-standing tradition of honoring the votes of the people and granting a new president a “honeymoon” period where at least some of their agenda could be enacted.
Current Senate Minority Leader McConnell formalized this strategy in 2010 after taking back control of the Senate in the midterm elections. McConnell; “The single most important thing we want to achieve is for President Obama to be a one-term president.”
Sen Mcconnell softened this a little, saying that if President Obama did a back flip and worked to achieve Republican goals like repealing his signature health care legislation and reducing the national debt, some Republicans could work with him. No doubt he said this with a wry grin.
Meanwhile the working people of the U.S. were in dire straits. The Stimulus Package, that all Republicans had opposed, did stop the free fall, did restore economic growth, but in the opinion of most economists it was a first step only, too small to restore lost businesses and jobs any time soon. This situation suited Republicans just fine. 10% unemployment had just handed them big wins in the midterms, they were in no hurry to see it improve before the presidential election in ‘12.
To insure this outcome they had laid a series of fiscal roadside bombs to blow the economy off course, to derail the recovery. These are detailed in this Brookings Institute report; The fiscal fights of the Obama administration (brookings.edu). Of course, while their strategy kept the congress in GOP hands in 2012 it didn’t hand them the White House…the economic sabotage continued.
This political game playing created real headaches at the Fed. Achieving full employment was half of their statutory mission. The Republican blockade of further stimulus, particularly deeply necessary infrastructure spending, coupled with their regular budgetary and fiscal sabotage, kept unemployment high and recovery slow.
The Fed had first used Quantitative Easing (QE 1) starting in ’08 to restore confidence within the banking sector, the members of which each held opaque and possibly toxic mortgage bonds and exotic investment instruments and were unwilling to resume interbank lending with other institutions that might be insolvent. The Fed had already reduced interest rates to an effective zero, the only cartridge left in their gun was quantitative easing, and so they did QE2 and later, QE3.
By the time Obama left office the economy had finally rebounded, with near record full employment and steady if not strong growth. The Fed reeled in its quantitative easing and looked for an opportunity to ramp interest rates back up to normal levels, to reload its main weapon for dealing with inevitable business cycle recessions, cutting interest rates.
Fed Chair Powell did this in earnest in 2018, hiking rates four times in anticipation that record employment levels and recent tax cuts would overheat the economy and spike inflation. It turned out that the trump trade wars with China and Europe were already holding back U.S. growth and there was no predicted “rocket ship” GDP growth of 5–6% in the offing…Powell had to back the rates down. The need to restore them closer to historic norms would have to wait.
The global pandemic crashed not only the U.S. economy but much of the global economy as well. With a “Republican” in the White House the Republicans in Congress had little taste for blocking stimulus Covid rescue spending. They readily joined the Democrats in passing stimulus spending that dwarfed Obama’s plan in ‘09…inflation worries be damned, there was an election on and they had hopes to hold the Oval and Congress.
Now, inflation has finally reared its ugly head, and though interest rate hikes are not exactly on point to lop that head off, they are deeply necessary for long term U.S. economic health.
A large cohort of Americans with fixed incomes depend on bond interest for their daily bread. Low rates create spikes and possible bubbles in all asset classes as capital investors compete to buy investments with possible healthy returns. The relentless rise in home prices is directly tied to low mortgage rates and this bidding up of prices, often by deep pockets “investment” players, is pricing far too many young people out of the market. And of course, with interest rates near zero, the Fed is unarmed in any confrontation with the inevitable business cycle recessions.
Chairman Powell will never say as much, the board of Fed governors are unlikely to crow about this opportunity, but they are ALL pleased to be “forced” to ramp up interest rates, and for good reasons that have little to do with inflation.