The Fed risks harming the economy more than it can help

Federal Reserve Chairman Jerome Powell testifies before the Senate Banking, Housing and Urban Affairs Committee on Feb. 26 in Washington.
Federal Reserve Chairman Jerome Powell testifies before the Senate Banking, Housing and Urban Affairs Committee on Feb. 26 in Washington. AP

As doctors pledge, “first, do no harm,” so too should the Fed.

Earlier this year, Federal Reserve Chairman Jerome Powell announced that interest rates would not rise as previously planned. The announcement came after the stock market became more volatile in response to investor concerns about the economic outlook.

Powell said, “The case for raising rates has weakened somewhat,” and that conditions “warrant a patient wait-and-see approach regarding future policy changes.”

The chairman is clearly concerned that U.S. monetary policy could hurt economic growth.

While growth slowed this year, by most measures we are doing very well. The Bureau of Labor Statistics reports that the unemployment rate fell to 3.8 percent last month, and the cost of living rose at an annual rate of only 1.5 percent.

In Idaho, the unemployment rate, at only 2.8 percent, is well below the national average. Meanwhile, prices in western U.S. cities like Boise are rising just slightly faster than rest of the country at 2.3 percent annually.

Peter Crabb.jpg
Peter Crabb

The Fed is rightly worried about the harm higher interest rates may do to these favorable economic conditions. But maybe, just maybe, monetary policy doesn’t do anything at all.

In 1913, Congress established the Fed and charged its governing body with maintaining a sound and stable financial system. When financial banks got into trouble, say by not having enough cash flow from their loans to pay their depositors, the Fed would lend to them at favorable rates until things improved. This “lender of last resort” role was all the Fed did for the early part of its existence.

It wasn’t too long, however, until politicians and Fed leaders began to think that they could influence banking activity, and therefore economic activity, by changing interest rates and/or the level of reserves banks held at the Fed. The Fed’s mission was changed to encourage economic growth and protect against inflation by changing the incentives banks have to lend.

In theory, this is a pretty straightforward objective. In practice, it may not work.

The unfortunate fact for monetary policy makers is that they cannot control or perfectly predict investor and banker behavior. For the past decade, the Fed has held rates well below historic averages and increased the U.S. money stock. Banks have plenty of cash to lend at low rates, but this easy monetary policy has not achieved the economic growth many expected.

It may be further argued that the low rates simply create volatility in the financial markets, which is not a new argument. The concept that money is neutral - that is, you can’t affect the real economy by changing the amount of money circulating - goes back to 18th century economist David Hume.

Since low rates may not help, the Fed’s guiding principle should be first, do no harm.

Peter Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa.