A short history of money, interest rates, inflation, deflation and how it always worked since 1937. Until 2007-2009. Part 1 of a three-part series.
WASHINGTON, December 18, 2015 – As a followup to Thursday’s Market Maven column, we promised to provide a little more insight as to what the U.S. Federal Reserve Bank decided to do this past Wednesday, why the nation’s central bank decided to do it, and what that might mean for investors as we look ahead to a momentous election year in 2016.
This is complicated stuff, but we’ll try to explain it in a meaningful way to investors who, like us, don’t have the time and inclination for all the shop talk and nitty-gritty details. But we’ll still need three columns to explain this coherently. This column is Part 1.
Without going back to ancient Greek and Roman history, let’s look very briefly at money the 20th and 21st centuries—our own contemporary time frame.
When you boil down monetary theory to its essence, the value of a national currency is directly related to how easy it is to earn it or obtain it. If we relate this to the U.S. dollar, that simply means that when the Federal government prints a lot of greenbacks, it tends to drive their value down. But when the government starts taking dollars out of circulation, they become more scarce and their value tends to go up.
At its core, dollar value, like anything else in a nominally capitalistic system, is a matter of supply and demand.
Traditionally, when the U.S. central bank—the Federal Reserve—decides that things are going badly in the economy—as in poor corporate earnings, layoffs, unemployment, dropping commodity costs, bankruptcies and the like—it needs to get, or “inject,” more dollars into the system and out into public and corporate hands. To oversimplify, this has traditionally meant cranking up the printing presses to create more dollars while lowering interest rates, making it easier for companies and individuals to borrow money to invest in plants and equipment and, for consumers at least, to buy more stuff.
The result, more or less, is inflation, which drives the price of goods and materials up, but also puts pressure on wages, stimulates sales, and ultimately stimulates more borrowing. Carefully done, this strategy gets a weak economy back into growth mode.
Although this is again an oversimplification to some extent, when the Fed gets money into the system, it’s historically been stimulative to the economy. But overdoing it can cause inflation to get out of hand, requiring the Fed to take the equal but opposite action.
When inflation gets out of hand, the Fed needs to get dollars out of the system. Traditionally, the initial step is to start raising interest rates. But it also means the Fed needs simultaneously to “drain” dollars out of the system, making them more scarce and thus more valuable in terms of purchasing power. At the same time, the Fed will generally “drain” dollars from the banking system by encouraging banks to “sell” more of their reserves back to the Fed. The Fed will tend to accomplish this by raising the interest rates on these funds to the point where they become attractive.
Rising interest rates tend to discourage the loaning of money, at least incrementally. In addition, as banks park more of their funds back with the Fed, those dollars are no longer available for lending, which, again incrementally, tends to dry up the supply of dollars available to loan to businesses and consumers. This is the traditional Fed method for sopping up “excess” inflationary dollars in the system—the money supply—which, if successful, gradually puts a damper on inflation that’s getting out of hand.
So, historically, the Fed formula has been this:
- If the economy is sputtering or perhaps in danger of “deflating,” i.e., deflation, the Fed will start to drop interest rates and crank up the U.S. Treasury printing presses, increasing the money supply by injecting dollars into the system; while also making it easier to borrow that money, and, hopefully, getting employment and the economy on track as a result of these stimulative efforts. This tactic gradually worked as the Fed discovered back in the 1930s. On the other hand, as they learned in 1937, if you fear incipient inflation prematurely and raise interest rates too soon, you can quickly short circuit a recovery.
- If, on the other hand, the economy is overheating, if wages and prices are going up too fast (inflating), and if the U.S. is starting to experience an ultimately inflationary environment that’s getting out of hand, the Fed has historically—at least since circa 1937—taken the opposite tack. In this situation, the Fed starts increasing interest rate, slowing down the printing presses, and actually taking dollars out of the system, i.e., draining them from the system, by encouraging and/or forcing member banks (most U.S. banks) to deposit more excess funds with the Fed by various means or inducements. Less dollars and higher interest rates slow things down either by discouraging borrowing and/or making dollars less available to companies and individuals that want to borrow them.
Since the Fed apparently learned its lesson after its seriously wrong turn in 1937—when it actually aborted a weak recovery from the Great Depression by raising interest rates too quickly—the nation’s central bankers have generally erred on the side of caution when confronted by either scenario.
So why is our 2015 Fed apparently repeating the same decision as the wrong one they made back in 1937? Stay tuned.
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