The Fed’s tightrope

As is well understood, the Fed operates with a dual mandate: to control inflation and to achieve maximum employment. Unfortunately, given the nature of the monetary tools available, the Fed is often faced with the Hobson’s choice of pursuing one objective at the expense of the other. That is, ultimately, the Fed can affect an easier monetary policy, a tighter policy, or one that essentially maintains the status quo. An easier policy seeks to stimulate economic activity and thus lower unemployment; a tighter policy serves to dampen inflationary pressures; and a neutral policy effectively puts monetary policy on the sidelines.

When I was in graduate school, I was taught that a tight monetary policy was a regime that slowed the rate of growth of the money supply and easy policy was one where the growth of the money supply accelerated. The Fed could largely affect these policy choices by adjusting the required reserves that banks needed to maintain, adjusting the rate the Fed charged banks that borrowed from the Fed’s discount window, and directly adding to or detracting from the money in circulation through its open market sales and purchases of securities.

These days, the mechanisms have changed somewhat. The Fed still allows banks to borrow from the discount window, and it also actively engages in open market operations. What’s different now is that the Fed no longer imposes reserve requirements. It also pays interest on bank reserves that are deposited with the Federal Reserve banks—a practice that began shortly after the 2008 financial crisis. The rate paid on these deposits, set by fiat by the Fed, has become central to the way the Fed now thinks and talks about its policy.

Whereas the rate of growth of the money supply used to be central to how the Fed discussed monetary policy, these days, interest rates are the primary focus. The Fed communicates this through its target rate for the federal funds (or Fed funds) rate. Historically, the Fed funds rate was the overnight rate banks charged each other for excess reserves that they would park in other banking institutions. These days, the market is somewhat transformed, as many other types of institutions besides traditional banks participate in it. In any case, by manipulating the rate the Fed pays on deposits that it takes in, the Fed exerts strong influence on the Fed funds rate and can move it up or down, virtually at its will.

Today, tightening generally means raising interest rates; easing means lowering interest rates; and a neutral policy essentially leaves things unchanged. The Fed’s current approach is to determine the rate it will pay on its deposits (and hence the Fed funds rate target) and then use its open market operations to try to harmonize interest rates in other markets with those of its deposit rate and the Fed funds rate.

In my view, this current orientation of the Fed is only a slight variation of the approach I learned in school. As a prelude, one should understand that by extending a loan, banks create money and expand the money supply. When the Fed lowers the rate it pays on deposits, it makes lending funds to prospective borrowers a more attractive alternative. Thus, by manipulating the deposit rate the Fed pays on the deposits it holds, it can either stimulate bank lending (easy money) or depress it (tight money).

So, what should the Fed do now? The fact that we’re currently experiencing both a weakening economy and an uptick in inflation puts the Fed in a bind, with each problem calling for an opposing policy. Its next decision is anticipated this week on Wednesday, and most analysts expect a 25-basis-point reduction in the Fed funds rate target. If consensus holds and the Fed does ease somewhat, the hope is that the adjustment will shore up the weakening economy without adversely affecting inflation too much. Only time will tell.

Regardless, what seems to be forgotten in this policy discussion is that the Fed is being tasked with correcting the problems of the making of the executive branch. That is, much of the weakening of the economy can be attributed to layoffs of the federal workforce, cutbacks in federal expenditures, and labor shortages due to massive round ups and detentions of immigrants leading to disruptions in production; and similarly, the uptick in inflationary measures can also be attributed at least in part to the indiscriminate imposition of tariffs virtually across the board on imported goods. Of course, in the MAGA mindset, America is in top form; but the Fed is a disaster. Go figure.

Given the current political situation, where Trump has been denigrating the Fed and pushing it to sharply reduce interest rates, I think the Fed may feel forced into doing something, merely to avoid being tagged as being a “do-nothing” institution. Accommodating to a small downward adjustment in interest rates may be a small compromise in independence, intended to protect the Fed from a more serious challenge to its authority in the future. My own feeling is that a one-time adjustment of 25 basis points one way or the other probably won’t be all that problematic. On the other hand, any statement suggesting that this immediate interest rate change might be the first of more to come would be.

Unfortunately, in recent years, the Fed has tended to signal prospective interest rate adjustments that it thought would be likely be making in the future, even while reiterating its intention to be guided by the data. I’ve always considered these longer-term interest rate projections to be in conflict with this commitment to following the data. Any inclination to follow one course of action prematurely, before corroborating data become evident seems both unnecessary and ill-advised.

And speaking of ill-advised… In any other time, the idea of a Federal Reserve Board member holding that post while also serving as the Chair of the Executive Branch’s Council of Economic Advisors would be unthinkable; but this is exactly what’s under consideration and what the Republicans in the Senate seem willing to abide with the nomination of Stephan Miran to the open seat on the Fed’s Board of Governors. By all indications, the Republicans are expected to rush this appointment though on Monday, allowing Miran to participate in the coming Board decision on interest rates that’s scheduled for Wednesday. The independence of the Fed from domestic politics has been widely recognized as being inviolate by all but a tiny minority. Not so any longer, at our peril.