Business reporters and political pundits exhausted themselves recently regarding the Federal Reserve System (The Fed), determining to lower the prime rate by one-quarter of one percent. Before you stop reading this, the column is really going to be about how this decision impacts your wallet. I will try to explain economics, interest rates and The Fed in less than in the amount of words that limited space allows.
The Victorian historian Thomas Carlyle in 1849 coined the phrase "economics is a dismal science" to criticize the Rev. Thomas Malthus, who posited in 1798 that the world's food supply could not keep up with the growth in population, which was one billion then and seven billion today. He preached abstinence and limiting marriage for poor people. He also said that war, starvation and disease would bring the population/food supply equation back in balance. No wonder Carlyle thought this economic theory was dismal.
Fast forward to 1992, when Bill Clinton's campaign manager, James Carville, coined the phrase, "It's the economy, stupid." This was one of three messages that Clinton stuck to when he beat George H.W. Bush handily, even though the successful Kuwait campaign left Bush One with a 90 percent approval rating. The other two messages were "Change vs. more of the same" and "Don't forget health care." So we have a dismal science that is so important that it wins or loses elections.
Here comes the economics. Very simplistically, there are two major methods governments use to manage the economy.
The first is fiscal policy. During the Great Depression, British economist and investor John Maynard Keynes said the government needs to spend its way out of the nightmare that saw breadlines and nearly 40 percent unemployment. This was called "pump priming" and President Roosevelt's New Deal was full of projects and work programs to prime the economy. The problem with this approach is that the money to pay for it expands deficit spending and requires higher and higher taxes as "short term" fixes become forever programs.
The other method is monetary policy and that is the province of The Fed, which was established during President Wilson's term in 1913. One basic principle of economics is called the law of supply and demand. The greater the supply of a commodity in relation to demand, the lower the price and vice versa.
What The Fed seeks is equilibrium for the supply of money in relation to the demand. One way to do this is to raise interest rates, which should slow down the economy or lower interest rates to stimulate the economy.
So if The Fed and other financial institutions believe that our 10-year run of good luck (Bull Market) is going to slow down or turn into recession (Bear Market), interest rates get lowered to stimulate the economy. Why is this important to everyone struggling to make ends meet? Variable rate loans are tied to Fed rates.
Mortgages may be tied to Fed rates or something called LIBOR (London Interbank Offered Rate). Credit card interest rates are tied to The Fed's decisions, or should be. This is important if you keep a balance on your cards. The stock market goes up and down in part based on The Fed's decisions. If you are lucky enough to have some savings or a 401(k), The Fed's decisions impact your net worth. Other countries have their own version of The Fed, which make decisions in part based on what we do. In fact, The Fed has helped other countries in financial trouble. When Mexico made some bad economic development deals which became known as the "Mexican Peso Crisis" after NAFTA was adopted, it needed a $50 billion bailout. Using the justification that economic instability and political unrest would expand illegal immigration to the United States, the package to resolve the crisis was put together during the Clinton years. Congress rejected a cash infusion, so loan guarantees were put in place which were repaid early with a $600 million profit to the guarantors, including the U.S. Treasury. It worked and the crisis was averted. This was a common-sense approach to the illegal immigration issue.
The takeaway is the chairman of The Fed is nominated by the president and confirmed by the Senate for a fixed term. Once in, they can’t be bounced by whim or Tweet. This is a good thing.
Messing with the economy for political gain is a very bad thing and impacts most people's finances daily. Let's leave these complicated decisions to the experts and not someone whose personal fortune just might be impacted by The Fed's decisions.
Roger Carlton is a columnist for The Graham Star.