How Monetary Policy Impacts the Economy
The United States economy is controlled in two ways: Fiscal Policy and Monetary Policy. Fiscal Policy is brought about through the political system as the Executive and Legislative branches work towards a particular agenda. In President Trump’s speech to Congress on February 28, 2017, Trump outlined his agenda and priorities for his administration. Among other things, Trump discussed increasing military and veteran spending and increasing infrastructure spending. He intends to lower the corporate tax rate and to provide tax relief for the middle class. All of these policies can drastically impact the economy. Fiscal policy generally changes as Presidential administrations and Congressional bodies change, based on their respective agendas. It is more difficult to predict how Fiscal policy will impact the economy because policies all-too-often do not come to fruition. The effect of Monetary Policy, on the other hand, is much easier to predict. Monetary Policy is controlled by the United States Central Bank, the Federal Reserve (“The Fed”). The Fed is somewhat insulated from political parties and political agendas, and is responsible for managing the US economy. The Fed often manages the economy by making changes to the money supply. Changes in the money supply impact inflation rates and interest rates, which ultimately impact investment and savings rates. Changes in both Fiscal Policy and Monetary Policy can have tremendous impacts on consumers, investors, and businesses large and small.
The Fed has four main priorities: keep prices stable, maximize employment, ensure financial stability, and ensure exchange-rate stability. While The Fed cannot set interest rates directly, it manipulates rates by changing the amount of currency in the economy. The central bank controls nominal interest rates by supplying the amount of money demanded at a particular rate. Thus, a decrease in the money supply leads to an increase in the interest rate, and an increase in the money supply leads to a decrease in the interest rate. The Wall Street Journal reports that Janet Yellen, chairwoman of The Fed, intends to slowly increase the rates over the next several months. If the Fed decreases the money supply, the demand for cash will increase. When demand for cash increases, banks increase the interest rate to accommodate that demand.
On December 16, 2016, the Fed increased the federal-funds target rate from 0.50% to 0.75%, the first time the rate has been increased since December 2008. Since the financial crisis, The Fed has kept interest rates extremely low (0.50%) in order to stimulate the economy. As a comparison, the rate was 5.25% in 2007. Many investors suspect a new rate hike will take place as early as this month. In a CNN interview, William Dudley, the President of The Federal Reserve Bank of New York furthered these suspicions by indicating that the arguments for a rate hike as early as March were “a lot more compelling.” Indeed, experts believe there is a 74% chance of a rate hike in March.
When The Fed increases the rates economists expect borrowing to decrease and saving to increase. Individuals and businesses take advantage of the earning potential of higher rates and invest more. Individuals and business borrowing generally slows down because higher rates make it more expensive to take out a loan or a mortgage. As the money supply decreases, we can expect inflation to decrease and the value of the dollar to appreciate. Low inflation and a more powerful dollar benefit individuals and businesses alike. A higher rate benefits companies who do business in the US because the dollar should command more purchasing power. Alternatively, companies that are highly leveraged (think energy, utility, and telecom companies) are negatively impacted by a rate increase since debt financing is more expensive. Since the financial crisis, borrowers have been The Fed’s priority. With an increase in the rate, we see The Fed’s priority slowly moving toward savers.
Janet Yellen has indicated that increases in the rate will happen slowly, in small increments, over time. The rate hike in December 2016 was 25 basis points, miniscule compared to 2007 levels. Despite the small increase, the S&P 500 dropped 0.8 and the Nasdaq composite fell by 0.5%. As subsequent rate increases occur in 2017, we can expect similar performance in the stock market.
President Trump is trying to use Fiscal Policy to further heat up the economy by increasing defense and infrastructure spending and giving tax breaks to corporations and middle class families, The Fed is using Monetary Policy to try to keep the economy from overheating. While an increase in the rate will immediately impact millions of American families and businesses, The Fed hopes that increasing the rate will achieve its goals to keep prices stable, maximize employment, ensure financial stability, and ensure exchange-rate stability. Only time will tell if the economy is ready for it.
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