Why we’re all keeping an eye on the interest rate

The New York Stock Exchange has continued well into this week its steady (and for many, confusing) decline. Among the other effects of that is the stifling of an earlier conversation about the Federal Reserve raising the US’s federal funds rate. An incentive typically retained for crises or to address inflation, a heightening of that rate would increase the interest on loans between banks, credit unions, and other institutions, ultimately raising the interest rates on most other loans and forms of investment in the broader economy. Since a low interest rate is so useful in a crisis, the argument goes, the already currently quite low rate should be maintained to give investment circles and other parts of the financial system a bit of a breather.

federal funds rateThe historical federal funds rate, from here.

A crucially missing part of that expectation that the Federal Reserve should keep the historically low rates is a very specific understanding of why the Federal Reserve lowers rates. In the view that argues for keeping the current rate, a lowered rate is in and of itself the goal. A lower rate, so the theory goes, means transactions happen. It’s an indirect and finance-heavy form of economic stimulus. Is the lower figure on the interest rate itself the necessary end though? Can’t the lowering of the rate also be in and of itself a process?

Financial institutions act a specific way before the rate is lowered, and then alter their behavior when it reduces. In short, it’s about changing how they act through changing expectations of how profitable a given investment, loan, or other action would be. The key word there is change. This is about altering expectations of what a given rate would be.

In light of that differing view of the federal funds rate’s power, what use is it in the situation of an anemic economic recovery and jittery investors? What’s more, there’s not really anywhere for it to go lower to. It’s tapped out as a means of promoting economic action that otherwise wouldn’t happen within the economy. While raising it is probably not the wisest choice either, since it’s possible that would create a ripple effect of rising and disincentivizing interest rates across the economy, the centrality of the interest rate in the on-going discussion of how the US government can respond to a disastrous week on Wall Street is a bit odd.

A more illuminating portrait of the economic situation, in which the federal funds rate is only a bit player, was painted by Paul Krugman. He noted that a key part of what’s gone wrong so far on Wall Street is indicative of an on-going pattern of crises: first the economic downturn of various Asian economies in the 1990s, then the the boom-bust of the US economy from the early 2000s on, then a 2009-2010 Euro crisis, and finally another currency crisis in many other less developed economy (most notably Brazil). Krugman links these together as a recurring pattern of speculative “gluts,” each fed by the former as a source of initial investment funds and feeding the latter by driving investors there after that specific economic bubble pops.

In essence, the uncertainty of investors that could pull their funds out of the US economy and create economic distortions elsewhere is the problem, and the possibility of a not-very-well-timed federal funds rate increase is simply a justifying moment of bad luck. That’s the spark that could light a powder keg of huge investing resources concentrated in globally a small number of flighty hands and given greater mobility than ever before historically. The interest rate can’t go up, and various political groups are noting that necessity, but the structural reality that has made that and virtually all other stimulant economic policies must-haves to avoid an economic catastrophe needs to be talked about as well.

Our financial system (like many others around the world) is essentially set up to fail, and at moments like these it seems like there might be a clear reason why: to make anything less than stellar news for the financial sector even more disastrous for everyone else. There’s no better way to keep the policies you want than to make them in everyone’s best interest.

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