The Fed should not raise or lower interest rates

When someone asks you whether the Federal Reserve should raise or lower interest rates, the proper answer is “No.” The Fed should do neither because the market, not a government institution, should set interest rates.

First, here’s a primer on how the interest rate targeting system works. The Fed is America’s central bank, or in reality, a system of banks. The Federal Open Market Committee, whose members the government appoints and are from member banks, sets Fed policy. The president appoints its chairman and the Senate confirms the appointment. Do the names Volcker, Greenspan, and Bernanke ring a bell? That’s because they were chairman of the FOMC. The media generally calls that person the Fed chairman. The current Fed chairman is Jerome Powell, who was appointed by President Donald Trump and reappointed by President Joe Biden. The group he chairs meets periodically, deliberates policy, and issues a statement to the general public that includes announcing an interest rate target.

But what interest rate do they target and how do they hit that target? Historically, the focus has been on a specific interest rate known as the federal funds rate. It is the rate that banks charge one another for very short-term loans, even just one overnight loan. Banks hold a certain amount of money in their vaults in case there is a bank run. That money is classified as “reserves.” When banks have more cash on hand than required as reserves, they lend that excess money out to banks that have fewer reserves than they need. This is done daily, and the interest rate these banks charge one another is the one the Fed targets. When the media says the Fed raised or lowered rates, this is the rate they’re talking about.

But the Fed doesn’t set the rate. It’s not like when government decrees a minimum wage or places a cap on the price of some good or service. Instead, the Fed indirectly influences the rate by depositing money with banks or withdrawing deposits from them. When the Fed deposits large sums of money in the banking system, cash becomes more abundant, and interest rates tend to be lower when cash is plentiful. When the Fed pulls money out, money is less abundant, and interest rates tend to be higher. When the Fed targets a rate, it’s not instructing the banks what interest to charge, it serves as an instruction to the Fed’s staff either to put money into the banking system or pull money out of it until the banks charge a rate close to the rate the Fed announced as the target rate.

This system is not designed for ease of understanding. But, though the system’s mechanics are housed in a black box of opacity, if one zooms out enough to get the big picture, we see that “lowering rates” and “raising rates” really mean expanding or contracting the money supply. Since the Great Recession, the Fed has added several other side gigs with odd names like “quantitative easing” and “Operation Twist,” but those are side maneuvers.

Now, raising rates means reversing a long trend of massive increases in the money supply that had been intended officially to stimulate spending to keep the economy moving. Left unstated is the reality that the government itself borrows incredible sums to finance massive deficit spending.

Why turn off the money spigot now? Because inflation is running wild. The Fed is trying to kill off the inflation it created, but the problem is that, in the past, such action has generally triggered a recession.

As I argued here, rates mirror national character, reflecting whether we are covenant keepers or covenant breakers, debasers or preservers of currency, gratification deferrers or those driven by animal spirits, savers or spenders. Nations with Christian character earn low interest rates. When the government’s heavy thumb suppresses rates on the scale, it distorts things. Government intervention distorts markets and causes misallocation of resources, creating economic bubbles. Reversing course to counter inflation deflates those bubbles.

Should the Fed raise or lower interest rates? Neither. It should stop setting a target rate and leave the interest rate setting to borrowers and lenders who have skin in the game. Let’s throw out the carnival mirror of distorted rates and see the truth about ourselves. And then let’s deal honestly with our financial vices.