INTERVIEW: Fed Up?

By Reuvain Borchardt

Jai Kedia, a research fellow at the CATO Institute’s center for Monetary and Financial Alternatives, discusses how the Federal Reserve’s tinkering with interest rates affects the economy.

The Fed’s performance since the pandemic has come under heavy scrutiny, as inflation soared. Initially it said inflation was “transitory.” Once inflation became excessively high and entrenched, the Fed sharply increased interest rates from March 2022 through August 2023, its fastest pace in decades.

Kedia’s research lies within the fields of monetary economics and macro-​finance. As an empirical economist, he employs various econometric tools to analyze the interactions between monetary policy or financial variables and business cycle indicators such as inflation and GDP.

Kedia Jai is originally from Kolkata, India. He has a Ph.D. in Economics from the University of California, Irvine. He received his B.A. in Mathematics and Business Economics from the College of Wooster in Ohio.

We often hear about the Federal Reserve raising interest rates to fight inflation. How exactly does that work?

Interest rates tell you how valuable it is to save, as compared to spending. Every consumer makes a saving or spending decision with their paycheck. The higher the interest rate, the more you want to save, the less you want to spend.

Inflation is a symptom of the economy overheating — too much money chasing too few goods. So in some sense, with raising interest rates what you want to do is prevent people from spending, or at least make spending seem less good as compared to saving. So when interest rates are high, consumers think it’s better to leave their money in a bank, in a savings account, or some sort of asset, and they spend less, so the demand for goods and services reduces. And when the demand for something reduces, its price goes down. So that’s what the Fed is thinking when it talks about raising interest rates to reduce inflation.

We can have a five-day conversation about whether it actually works!

Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” How does cutting interest rates relate to cutting the money supply?

You could reduce the money supply or increase the money supply, and that’ll increase or reduce demand accordingly. But since the Friedman era, it has become much more common for the Fed to focus on interest rates primarily as the tool for monetary policy. Now, remember that the Fed does not directly “control” rates. It sets a target rate and uses open market operations and such to affect the actual funds rate, so technically Friedman is still correct. Even the interest rate approach is still changing the relative value of money which thereby affects inflation.

Do you think raising interest rates is the appropriate way to fight inflation? I mean, I’m sure you’d say that they never should have kept rates that low in the first place and that that fueled inflation. But once we do have inflation, do you support these rate hikes as the means to fight it?

Yes. I have papers at Cato saying that they should have increased rates much earlier than they did, and that part of the reason inflation got out of hand is that they were actually reducing the interest rate when inflation was increasing and they should have been raising the interest rate.

Since post-COVID inflation started, monetary policy has been particularly poor.

They haven’t even been following their own guiding principles; they’ve just been saying things like “inflation is transitory,” which, of course, we now know was wrong.

So I do agree that the Fed was right in its recent interest-rate increases. How much of an effect that’s going to have is debatable. Still, supply factors are the primary determinant of what does and doesn’t cause inflation. The high inflation numbers we saw were primarily because of supply shortages and gas prices, which is something that the Fed can’t exactly control.

You said the goal of raising interest rates is to reduce demand. Does it reduce demand because the consumer finds money harder to come by, or is it because the consumer is now incentivized to keep money in the bank rather than spend it because he is getting a higher interest rate on it?

It’s theoretically the second one. Although if you look at my savings accounts, it doesn’t seem like the Fed’s raising interest rates have affected them yet!

But there are other factors as well on how raising interest rates affects the consumer. Part of the way you can stymie demand, for instance, is when the Fed funds rate increases. The Fed funds rate is sort of the benchmark interest rate, and then all the other interest rates theoretically take that as a signal to increase or decrease their own rates. So when the Fed funds rate is high, mortgage rates will be higher, auto loan rates will be higher, credit card debt rates being financed through the prime rate will be higher. That’s another way that you can curtail consumption, because with high interest rates people buy less, and wait to purchase a home or a car. (There is a lot of debate whether the funds rate actually trickles down to the other rate but theoretically this is the strategy.)

You want to bring inflation back to the Fed’s target of 2%, and the way that’s done is through limited spending. So you target the consumer, make the consumer spend less, reduce demand, thereby bringing inflation back down.

So reducing demand is not the end, but the means to the end of stopping the devaluing of the currency? 

Correct.

We always hear about the Fed’s target of having inflation at 2%. Why is the ideal inflation rate 2% rather than zero?

There doesn’t seem to be any reason why. You would imagine that inflation should be at zero. Econ historians will be able to answer this question much better than I will. But there’s a lot of emphasis in our economy to make sure we don’t have deflation, which can have much worse effects on the average person than inflation. The Great Depression was a deflationary depression. Few people alive today have lived during the Great Depression, so we have sort of forgotten how costly deflation was.

So to prevent deflation, the Fed sets a 2% inflation target as essentially a cost of doing business, so we don’t ever reach a position where the value of money is being deflated.

So even in the Fed’s perfect world, the ideal rate would be zero, not 2%, but they try to keep it at 2% as a buffer against deflation? 

Thats completely correct. 

Ideally, you would not have any change in the value of money at all. But given that we know that that’s not possible because shocks to the economy will affect the value of money, you’d much rather set the inflation rate at 2% so that if there are shocks, they will maybe bring it down to zero, rather than to  deflationary territory.

Is part of the reason they seek a 2% inflation rate because they want people to spend rather than just leave it in the bank, and causing the money to be devalued over time is an incentive to spend it?

Some people have theorized that; I don’t particularly have an opinion one way or the other. I approach this very much from an academic point of view, so that’s why you heard my deflation spiel.

Whatever I‘ve discussed is based on econ theory; I am by no means endorsing one way or the other.

I’m speaking in the manner that we’d teach this in a lecture.

When people commonly talk about “the Fed raising rates,” what exactly are they raising and how does that affect people?

The Fed funds rate is the rate at which banks borrow from each other.

Banks have reserve requirements. So at the end of each day, a bank may see that it’s a few hundred thousand or a few million short, or has a surplus, and to meet their reserve requirements, they borrow from each other. The Fed funds rate is the interest rate at which they borrow from each other.

The Fed sets a target for this rate (say 5 to 5.25%) and conducts monetary operations to bring the rate within this target.

Why does the Fed get to set this rather than it being a typical loan where each bank sets its own rate?

That’s an excellent question.

I’m a libertarian, so you probably know my view on this, which is that I don’t think the Fed should be actively managing the economy. We’ve gotten used to the fact that this is how things have been done for like a hundred years.

There’s no reason why the Fed should be doing this other than a claim of practicality and good performance. Essentially a “when we do this it works out well for the economy” kind of argument. If you looked at the economy from 1985 through before the financial crisis, there might have been an argument for that, because our macro variables were fundamentally not very volatile. The Fed took a victory lap with that. But there’s tons of conflicting evidence whether it was really their performance or good economic luck. Certainly since the financial crisis they cannot claim their performance has been good.

And the rates on these short-term loans that banks make with each other affect things like mortgages, car loans and credit cards. 

Theoretically, yes. The funds rate trickles down to other borrowing rates and affects the consumer. Again, this is debatable.

And when interest rates are raised, it raises the incentive to save rather than spend.

Theoretically, yes, though on all my checking and savings accounts, my interest rates are virtually non-existent even after the Fed has raised rates. Take that for what you will. But yes, theoretically, yes.

What is the correlation between interest rates and the stock market? 

This is very difficult; you want to be very wary of making predictions. The stock market is probably the fastest-adapting institution in the economic system. It is constantly evolving according to expectations.

And so essentially, the stock market is capturing economic conditions, in some sense. So when interest rates go up, the expectation is that we’re going to start entering recession territory, which means lower corporate profits, lower shareholder value, stuff like that, which in turn causes the stock market to go down.

The interest rates are signaling to the private sector:  It’s time to cut jobs; there’s going to be unemployment; economic conditions are going to get worse. And there’s the consumer effect: If consumers are spending less, that means that there’s less money for corporations. So corporate profits are reduced, thereby affecting the stock market.

But overall, there’s just way too much going on in the stock market to concretely extract causal relationships.

If stock prices start shooting up, how do we know if that’s because of inflation or because the economy is good?

The stock market is an evolving entity, taking into account the private sector’s expectations too. So, it can’t just be because of inflation because the private sector would expect demand to fall in the future whether because of natural reversion or an expectation that the Fed would raise rates to curtail demand. In general, I go back to my previous answer. It’s best not to draw too many conclusions from short-run fluctuations in the stock price as there’s usually a multitude of information being incorporated into the final market stock price that you’re seeing.

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rborchardt@hamodia.com

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This interview originally appeared in Hamodia Prime magazine.