Let's Know Things

This month we talk about the Federal Funds Rate, inflation, and Continentals.

We also discuss the Fed, recession, and supply-side economics.

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Transcript

Historically, issuing currency not made of or directly exchangeable for something like gold or silver has been a bit fraught.

Many currencies, even those with backing from businesses or government institutions have found that swings in adjacent markets and issues related to reputation can cause their currency to balloon or collapse in value in ways that make it less useful: if you're a banker that issues coins meant to be worth about the price of a loaf of bread apiece and those coins are suddenly either worth a thousand loafs of bread, or if you require a thousand coins to get a single loaf, your model for managing that currency, including practical issues like minting and distributing the coins, can fall apart pretty quickly.

Many governments, especially but not exclusively the young governments of fresh or newly revolutionized nations, have had trouble with this sort of thing at some point.

Colonial governments in what would eventually become the United States had issues related to their use of several dominant European currencies at the time, which left them with a relative lack of control over the value of this coinage, which in turn incentivized them to produce a Continental currency, which were sometimes called Continentals, in the same way you might say Dollars, when the Revolution movement started churning up new necessities, including the need to be able to purchase arms and other equipment without relying on coinage issued by the very government against which they were revolting: the British.

These Continentals were issued by the Continental Congress, which was the temporary government established in opposition to the British government, and which was ultimately phased out in favor of the US government, when that became a thing.

In the meantime, though, this group, which itself was ever-changing in shape and composition, also had ever-changing ideas about how money should be managed in the nation they were struggling to create; even to the point that individual states were allowed to produce their own Continental currency, which led to an awkward situation where different Continental banknotes were backed by the implied future tax revenues of a bunch of different governmental entities that didn't exist yet. Thus, they all had different and ever-fluctuating perceived values, and most of them depreciated in value pretty rapidly because of that uncertainty, but also because some of these banknote-issuers were keeping the presses running day and night, and overproducing their respective note—causing a kind of inflation in this market.

This experience with overproduction and with a whole lot of counterfeiting of Continentals, mostly by the British, during the Revolutionary War, shaped the burgeoning US government's approach to banking, leading to the implementation of centralized control over money-issuance—so states and individuals couldn't print legal tender anymore, just the federal government—and in 1791 the First Bank of the United States was allowed to open up, followed later by two other central banks, the Second and Third Banks of the United States, the latter of which came into being in 1913 and still operates, today.

1913 was an important year for banking in the US for another reason, too: it was the year that the Federal Reserve Act was passed, and that act created the US's Federal Reserve System.

There was a bank panic in the US in 1907, which sparked a financial crisis that disappeared about 50% of the New York Stock Exchange's value over the course of about three weeks.

There was already a recession going on, and this panic stirred up a frenzy of bank-runs that worsened the problem.

A lot of businesses and banks went bankrupt as a consequence, and there were some finicky, industry-specific variables that fed the panic, but the macro-scale issue was that there was a lot of market manipulation happening, little regulation in the banking space, compared to some other countries, at least, and a decreasing amount of liquidity provided by the banks—which basically means it was tough to get a loan for any purpose; credit was scarce.

The Federal Reserve, which came into being as a consequence of the Federal Reserve Act, was meant to serve as a centralized power structure that would manage and wrangle the variables that would sometimes spiral out of control into market panics and recessions or depressions.

It had been decades since the country even had a central bank, and this new act and this managing body would essentially create a system of banks and bureaucracy that would tweaks variables to keep things ticking along healthily, serve as a lender of last resort, which in turn provides a baseline set of numbers that other banks could use as a default to shape and adjust their own, and as a manager for the US money supply, overall.

The Federal Reserve, often just called The Fed, gained additional powers and responsibilities in 1933 when it was expanded to include an Open Market Committee, tasked which overseeing the agency's open market operations—which in this context mostly means buying or selling government bonds on the open market as a means of adding or subtracting liquidity from the market. And in 1977, the Federal Reserve Act was further amended to require that the agency "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."

Which basically just formalizes what this group is supposed to do: maximize employment levels, keep prices stable, and keep long-term interest rates from getting too high or falling too low.

There are good arguments to be made—and they have been made, over and over since this governing body came into being—that centralizing power over so many fundamental aspects of the economy is not ideal, as it sequesters power in few hands, regulates things that some people don't think should be regulated, and gives more power to the Federal government, which some people are ideologically opposed to.

Despite these criticisms, though, it's been argued that a lot of the economic turmoil we've experienced since this body came into being would have been worse, lacking this group's frameworks and nudging of things back onto the rails: I don't think anyone is claiming they've done a perfect job, and a lot of changes have been made to how they operate, based on previous errors and blindspots, but there's some evidence they've helped the economy quite a lot, as well.

In some situations, like, oh I don't know, when there's a global pandemic followed by a land war in Europe, and everything is weird and unfamiliar because of these once-in-a-generation-or-less variable explosions, there's some evidence that this kind of group can keep things stable in part because of what they represent: their existence and their planning—and statements about that planning—can move markets almost as effectively as the implementation of whatever plans they make.

What I'd like to talk about today is the Fed, and how a recent decision about interest rates may reverberate through the global economy.

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The article I'd like to unspool today comes from the New York Times, and it's entitled:

Federal Reserve Walks a Tightrope Between Inflation and Recession

The most recent US consumer price index data shows that inflation hit 7.9% on an annual basis in February.

That means from February 2021 to February 2022, the price of buying things in the US cost 7.9% more, on average—at least for the bundle of goods and services they aggregate to come up with this general figure, which is meant to be broadly representative of the public's typical expenses.

At the core of inflation is the concept that money can lose value with time: I can buy less with a dollar today than I could a year ago because of that 7.9% inflation—and though that won't be a universal thing, and it's different for every category of good and service, differs between locations, and so on, it's a broad reading of the shift up or down in terms of what the currency we use can buy us at a given moment.

In general, the Fed aims for an inflation rate of about 2%: that's considered to be a healthy level in many wealthy countries in particular, and in early-2012, the Fed brought the US into accord with many other nations and started targeting 2% inflation, as that tends to be the level at which money isn't losing value too quickly, but the economy is still able to move forward at a steady and optimistic clip.

To get it lower than that, you would theoretically need to shut down a lot of the variables that tend to stimulate growth, like the availability of cheap credit.

Going too hog-wild with cheap credit, though, can tip the economy into an inflationary posture, if you're not careful. Cheap credit is kind of like an economic fuel because it allows people to buy stuff, including assets like houses, and allows businesses to invest in their own assets, which tends to lead to healthier, more productive businesses that can make more stuff, but also employ more people.

An inflationary spiral, though, can sometimes occur if you're not careful and allow an economy to run too hot, too long.

Such a spiral is usually the consequence of dynamics between wages and prices: as employees are able to demand higher pay, leading average wages to go up, businesses tend to raise their prices to account for those higher wages.

People look at the prices of goods and services going up and start to demand even higher wages, and that's where we start to see spiraling activity: higher wages lead to higher prices which lead to higher wages which lead to higher prices, and at some point the dollar in your pocket is worth a small fraction of what it was before the spiral kicked off.

Far more ideal, according to most mainstream contemporary thinking on the matter, is to tap the breaks lightly periodically to ensure things don't get too hot and overblown, leading to uncontrolled inflation, but also making sure it's just a light tap here and there, so that you slow fairly ponderously, which allows you to then speed up a little or slow down even more based on what happens in the market: it's all about keeping things balanced and preventing sudden shifts one way or the other.

The primary tool that the Fed utilizes to tap those breaks is what's called the federal funds rate, which is the interest rate banks and credit unions use when lending each other money overnight.

Basically, money is continuously shuffling around between these institutions in order to maintain the legal reserve balances: they need to have a certain amount of money on hand based on the amount of money they're loaning out and using for other purposes.

If they don't have enough on hand, they can borrow money from another institution and pay them a small amount of interest on the money borrowed.

In this way institutions with more money than they need can earn a small amount of interest on that excess, and banks that, for the night, don't have enough on hand to meet their legal obligations can close the gap and stay on good terms with the government.

The Fed shapes this interest rate by using their open market powers to nudge things one way or the other, but the consequence of this swirl of background activity is that the Fed decides how much they want to raise or lower the interest rate, they announce any changes they decide upon, then they tweak some market dials and push some economic buttons and things move in that direction.

This interest rate, because it's so fundamental to banking activity, then goes on to inform what banks pay people who have savings accounts, what rates are attached to mortgages, and other baseline numbers of that kind. These baseline number-shifts then go on to influence other things throughout the economy, from the prices of products at the grocery store to the cost of attending a concert.

This piece in the Times is about a recent Fed announcement that they will be raising the federal funds rate by a quarter-percent, and plan to increase this rate six more times this year, likely by small amounts each time.

Interestingly, this mechanism for controlling inflation has generally been considered a potent tool if the inflation is coming from the right place—usually, demand-side elements.

The difference between supply-side and demand-side inflation is that the former is primarily the consequence of not enough stuff being made or shipped or arriving on shelves, or a lack of workers to perform services, while the latter is usually the consequence of too much demand: there's a normal quantity of stuff on shelves and services available, but the demand for these things increases to such a degree that there's a shortage and consequently, prices go up.

The argument being made right now by some economists and analysts is that these interest rate increases, though they're being carefully deployed and can thus be adjusted over the course of the year as necessary to account for swings in either direction, may not have as much of an effect as some people think because a lot of the inflation we're seeing right now is not the consequence of people wanting to buy too much stuff, but rather because supply chains are snarled and manufacturing has been kneecapped by the pandemic.

We've had two years of infection waves and death and early retirements caused by fear and change and businesses closing and norms shifting.

We've also had two years of trucks and ships and trains being backed up, prices of shipping containers skyrocketing, and entire cities shutting down, leaving gaps in manufacturing schedules, but also requiring vehicles re-route and make new plans.

The system we've relied upon for several decades to get us everything right as we need it, in other words, has been set on fire and kicked around, and we're seeing pricing-weirdness because of all that uncertainty and all the investments that're being made in an attempt to bypass those snarls and shut-downs and all the trouble businesses are having finding skilled people to hire.

Raising interest rates might not change much, then, and it may be that instead all we'll see, or what we'll primarily see, are the downside effects of raised interest rates: namely, the slow-down of the economy and the increased likelihood of a recession because of that slowdown.

Part of the impetus to do something here, based on what Fed Chair Jerome Powell has said up till this point, is to avoid that aforementioned spiral where inflation pops up, that raises wages and prices and fears of future inflation, and that, in turn, sows the seeds of the next portion of the spiral: folks anticipate prices going higher and demand still-higher wages, rents go up because landlords anticipate higher inflation, and don't want to lock-in low prices for the course of the lease if the value of the money they're charging will change dramatically by the time that lease is up—all of this adds up and contributes to the momentum behind inflation spirals, and doing something, even if that thing doesn't necessarily influence the intensity of inflation directly, could still have a positive impact in that it could help reassure people that something is being done, and they needn't demand higher wages and raise rants and the prices on the products they're making out of preemptive concern about future inflation. This feels like a solution being implemented, and that may help ease the panic.

Unfortunately, although a lot of the variables that seem to be pushing inflation right now are on the supply side, there are still so many unknowns related to the pandemic and to the conflict in Ukraine—and this will remain true even after both events have been settled, to some degree—that we could see reverberations from both, and all other associated sources of uncertainty, for years into the future. And such uncertainties needn't be localized to be impactful: this sort of thing travels, like an economic butterfly flapping its wings and causing a monetary typhoon on the other side of the planet, because of how interconnected everything is these days.

There was a rumor that the Fed, until Russia invaded Ukraine, was thinking about starting with a half-percentage point increase instead of the quarter-percentage point they ultimately went with, because that would have maybe allowed them to slow things down faster, which could have then, in turn, reduced inflation faster, and possibly eased people's minds about inflation faster, as well, truncating some of that geographic and chronological inflation-worry sprawl.

The stated aim of the Fed, though, is to go for a soft landing, and that means when there are forces at play that could slow things down or cause folks to worry about or lose trust in the market, you maybe don't want to hit the brakes too hard, lest you tip things in the opposite direction, into a recession, rather than simply out of an inflationary period and into something calmer and more stable and normal.

The Fed funds rate has been at near-zero since March 2020—it was dropped that low as part of an attempt to keep the economy chugging along, despite the emergence of a global pandemic, and that seemed to work pretty well, by all indications.

It had been lingering around the 2 to 2.5% range in 2018, and though it dropped a little in 2019, these past two years have still been an unusual period in that the rate has been so low; so any goosing of those numbers; might be perceived as especially impactful, both because it now seems unusual to have a higher federal funds rate, and because many businesses have been recalibrated for a world in which credit is cheap and easy to get.

We're also seeing the effects of a global shift toward renewable energy—and all the geopolitical tumult related to that shift, which we're still just at the beginning of—alongside the effects of so many countries injecting gobs of money into their economies during the pandemic; which by all indications was a pretty successful effort overall, in terms of keeping economies chugging along and individuals safe, but which may be contributing, even if only in some small way, to these inflationary effects, and we just really don't know enough to be able to say if that's the case and how much, yet, with that and with the renewables push—so we're navigating around some opaque forces that we haven't encountered on this scale before, and that is almost certainly muddling our understanding of where we're at and what we need to do to get to something more stable.

Many other nations are at similar points in their economic circumstances, right now, and are likewise raising their key interest rates and generally tweaking their formulas to account for this reality while dodging both inflationary and recessionary extremes—the UK recently raised theirs for the third time in a relatively short period of time.

It'll almost certainly be years before we know the outcomes of what we're doing today, however, and the Fed has indicated that they don't expect inflation to reach something close to their targeted 2% rate until sometime in 2023, at the earliest.

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Show Notes

https://www.nytimes.com/2022/03/17/business/federal-reserve-inflation-recession.html

https://www.wsj.com/articles/feds-bullard-explains-fomc-dissent-warns-on-credibility-risks-11647604875?page=1

https://www.bloomberg.com/news/articles/2022-03-18/summers-says-fed-will-need-to-hike-to-4-5-to-cool-inflation?srnd=premium

https://www.bloomberg.com/news/articles/2022-03-18/rising-mortgage-rates-won-t-be-enough-to-end-u-s-housing-boom?srnd=premium

https://www.axios.com/fed-rate-increase-698953fc-84a0-401c-ab40-9d95adcea51d.html

https://www.npr.org/2022/03/18/1087272336/americans-will-feel-the-impact-as-fed-raises-rates-heres-what-you-should-know

https://www.theguardian.com/business/live/2022/mar/17/bank-of-england-interest-rates-inflation-oil-markets-sterling-russia-bond-payments-business-live

https://finance.yahoo.com/news/bank-of-england-raises-uk-interest-rates-pre-pandemic-levels-inflation-120137640.html

https://www.bbc.com/news/business-60763740

https://www.newyorkfed.org/markets/reference-rates/effr

https://en.wikipedia.org/wiki/Federal_funds_rate

https://qz.com/2142974/what-do-interest-rate-hikes-do/

https://en.wikipedia.org/wiki/Inflation_targeting

https://www.investopedia.com/terms/f/federalfundsrate.asp

https://en.wikipedia.org/wiki/Federal_Reserve

https://en.wikipedia.org/wiki/Federal_Open_Market_Committee

https://en.wikipedia.org/wiki/Federal_Reserve_Act

https://en.wikipedia.org/wiki/Early_American_currency

https://en.wikipedia.org/wiki/Panic_of_1907

https://www.investopedia.com/terms/f/fiatmoney.asp

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