Fed’s Move Could Restrain Economic Growth

In his 1997 book, One World, Ready or Not: The Manic Logic of Global Capitalism, William Greider likens the global economy to a great machine, complicated and powerful, capable of both great creation and great destruction — but with no one at the wheel.

“In fact,” Greider wrote, “the machine has no wheel nor any internal governor to control the speed and direction.”

The U.S. economy is a bit like that, except that it does have one main control: a brake controlled by the Federal Reserve. The Fed’s brake pedal is the power to set the federal funds rate, the interest rate that big banks charge each other for short-term loans.

Lowering the rate is like easing off a brake. Raising it essentially applies a brake to the entire economy, making it more expensive to borrow money for homeowners, small businesses, towns and school districts; depressing investment and, along with it, stifling job growth.

Why would anyone want to apply a brake to the U.S. economy, as the Federal Reserve did Wednesday in deciding to raise interest rates?

Think of the U.S. economy as a big locomotive steaming up a hill. When it gets to the top and starts rolling down, it picks up speed. If the engineer doesn’t put on some brakes, the train might derail when it goes around the bend at the bottom of the hill.

There’s just one problem with the Fed’s decision to raise rates now, for the first time in nearly 10 years: There is no hill, and there is no bend at the bottom of it. Well, maybe there’s a small hill, but the bend at the bottom isn’t very sharp, anyway.

When the Fed raises rates, intentionally slowing the economy, it normally does so out of fear of increasing inflation. But inflation has not been going up. It’s been holding steady at just under two percent (even lower, if you count food and energy costs), which is the Fed’s target.

And even though the economy is chugging along far better than it was when the Fed reduced interest rates to the near-zero level where they’ve been for so long, it has yet to fully recover from the shock of a global financial collapse and the deepest recession since the Great Depression.

So why put on the brakes?

In a ferocious column last September, New York Times columnist Paul Krugman said Federal Reserve officials talk to too many bankers, and bankers really, really want rates to go up.

It’s not hard to understand their reasoning. Low rates are bad for them.

Sure, it’s cheaper for them to hold deposits, but bankers make money on the difference between what they pay on deposits and what they can charge for lending — what economists call the net interest margin.

When they can borrow money for next to nothing and interest on deposits is down to the fraction of a percent, downward pressure on what bankers can charge is tremendous. So you can understand why they want rates to go up.

But, as Krugman points out, it’s less clear why policymakers would feel compelled to go along.

He writes: “The appropriate response of policy makers to this observation should be, ‘So?’ There’s no reason to believe that what’s good for bankers is good for America. But bankers are different from you and me: they have a lot more influence.”

There simply is no policy argument that can prove that intentionally slowing the economy right now is a good thing for anyone but bankers (and people with very, very large savings accounts; though the impact on savings interest rates is liable to be tiny compared to what happens to mortgage rates and other borrowing costs).

The Fed’s action will mean lower growth, fewer jobs, declining wages — all to prevent inflation that shows no sign of emerging.

As Krugman pointed out in a November blog post, wage growth has remained well below pre-crisis levels, even with recent improvements. He argues that the Fed shouldn’t even consider a rate increase until both inflation and wage growth are above where they were before the financial crisis.