[dropcap custom_class=”normal”]The Federal Reserve has been dropping hints that they plan to raise rates for the past 8 months. Yet, at each opportunity to do so, they have postponed the decision to a future date, claiming that timing wasn’t right for a rate increase. If they don’t act soon, they will lose credibility with investors and put themselves in an untenable position should the economy falter.[/dropcap]
Another recession is likely coming. It may be because of European market contractions after the Brexit vote, or a natural result of the business cycle. The economy experiences periods of retraction and periods of expansion. What goes up must come down. Whatever cliché one chooses to use, the Fed will need to be in a position to ease the inevitable decline in economic productivity.
To do so, the Fed has two tools at its disposal. First, it can issue proclamations. Investors of all stripes respond to the statements made by Federal Reserve officials, particularly Chairman Yellen. She has used this power to encourage people to borrow by continually suggesting that interest rates would go up soon. The incentive to borrow creates a slight expansionary pressure on the economy, which has helped to create jobs, promote business growth, and increase productivity.
What drives this power, though, is the belief by investors that the Fed will follow through on its statements. As more time passes without a significant increase in interest rates, that power wanes. Eventually, investors will cease to find the Fed’s statements credible, and act on other economic signals. This will put the Fed in a difficult position during the coming recession, since they will be unable to use the threat of rising interest rates to stimulate private borrowing.
Second, the Fed can lower the prime rate. This is the rate that the Federal Reserve charges other banks to borrow money. It determines a wide variety of financial factors, including the rates on mortgages, CD’s, and corporate bonds. For the past several years, interest rates have been at historic lows. While it is possible to drive interest rates below zero, it’s at least impractical and probably a bad idea. If another recession comes while interest rates remain this low, the Fed will have nowhere else to go.
There are other long shot strategies the Fed could employ in the face of recession, but these are fairly desperate. Mostly, they involve direct infusions of capital into lending institutions. This can encourage reckless lending, as the institutions are playing with “house money.” That makes these “helicopter money” strategies a desperate move.
Much more likely, the Fed will raise interest rates before another recession hits. This will restore the two more reasonable tools to their belt, and enable them to manage monetary policy more easily.