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Federal Reserve: Rising Interest Rates Raise Two Key Questions — Neither Is Inflation Or Recession

Fed Chairman Powell confirmed market expectations of a Fed Funds rate of 4%, with more to follow. The news caused the usual negative media coverage and a short-lived stock market decline.

So what now?

To answer that question, we need to understand why the Fed rate hike is a positive step forward.

After years of earning almost nothing from their short-term savings and investments, savers, investors, funds and organizations are finally receiving meaningful interest income. Granted, it’s still not enough to offset the purchasing power erosion of inflation, but a “real” (inflation-adjusted) percentage is coming. That is, as long as the Fed holds to allow interest rates rise.

“Why do you say ‘allow’?”

Many (most?) people have forgotten that the main task of determining the price of money (interest rates) is the capital market (money) – not the Federal Reserve. Through the extensive, ongoing bidding and bidding process, agreed interest rates are determined.

Here’s why that process is superior to the Federal Reserve’s: (Underline indicates main points)

Especially important are the main advantages:

  • First, both buyers and sellers offer or receive a fair interest rate at the time the transaction is made.
  • Second, capital resources are allocated to highest/best use (versus abnormally low rate used for second-rate or selfish actions).
  • Third, rates are set continuously during market hoursnot with an “interest event” that only happens a few times a year

In rare times of financial stress, when the capital market (money) cannot function fully, the Federal Reserve can step in to restore the market. The dire conditions in 2008 were one such time, so the Federal Reserve stepped in and pushed interest rates to an all-time low of nearly 0%.

However, as conditions improved in 2009 and beyond, Fed Chairman Ben Bernanke decided not to allow the capital (money) market to set short-term interest rates. Instead, nearly 0% was his base rate, rationalized by his view that the economy was not good enough. This approach was eventually seen as normal, leading to the belief that it is the job of the Fed to set interest rates.

The damage that the 14-year, abnormally low, Fed-set interest has inflicted on savers, investors, funds and organizations is financially and reasonably enormous – and cannot be undone. In addition, there is a lost realization and understanding that successful capitalism requires a robust capital (money) market to set interest rates. Ironically, the Fed’s own multi-year reporting is now hindering the rate hike. The actions are viewed negatively – as a damaging tightening that will lead to a recession.

The only way to “make things right” is for the Federal Reserve to stop keeping interest rates low and… allow the fully capable capital (money) market to fully function and the long-missing market interest. Hopefully that’s where this Fed is headed.

The question no one asks

Since the capital market (money) can completely determine the market interest rate, why doesn’t the Fed just step away?

“Well, interest rates could skyrocket.”

Yes, the capital (money) market rate would be higher than 4%. But that fact simply means that the Fed will continue to keep interest rates low and below the appropriate level. And that means the Fed continues to have an easy money environment, with its actions not yet leading to a real tightening. Therefore, instead of triggering a recession, the rate hike frees the financial system from abnormally low rates that cause weak and selfish actions.

Moreover, the Fed won’t protect us from an untied, runaway interest rate. In the capital market (money), all participants can change their bids and requests, enter and exit. The market is where all these forces converge and provide an understandable, high interest rate level in real time.

Another point to remember is that the Fed’s new 4% rate is well above last year’s nearly 0%. So while current capital market rates would be higher, there is now less distance to travel. How far stays? We won’t know until the capital market (money) is fully functioning. At that point, the rate depends on the terms and conditions that investors (capital providers) and borrowers (capital users) are willing to accept jointly.

In summary: Yes, the interest rate level on the capital market (money market) is higher than the current 4% set by the Fed. But know that the market rate will be appropriate – that is, fair, equitable, understandable and accepted by the market participants. The same cannot be true of the Federal Reserve’s 12-member decision-making process.

The bottom line: The Federal Reserve’s role is to support the capital market, not replace it

Capitalism makes the US economy strong – not Federal Reserveism. The long-held view of the Fed’s role in the capital (money market) is as the lender of last resort, to ensure that the US financial system does not freeze or collapse. As in 2008, when conditions spiraled out of control and the capital market (money) came under pressure, the Fed can step in to provide support and restore confidence. But then the Fed’s role is to leave and let capitalism regain its fully functioning capital markets.

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