What does it mean when the Fed raises the interest rate? It helps to first understand how the Fed raises the rate, which may surprise some people. The Fed does not "set" the interest rate as it might, for example, by declaration or edict or by fixing prices. No, it targets a higher interest rate by contracting the money supply until that money supply intersects the market demand for money at a higher market-clearing rate of interest.
How
does the Fed reduce the money supply? Typically by conducting open market
operations, which is the purchase or sale of government securities by the Fed.
To raise the money supply, it purchases new government securities, paying
for them by creating--out of thin air--reserves for the commercial banking
system. To reduce the money supply, it sells securities which shrinks the
amount of deposits in circulation in the economy. In other words, it reduces
the liquidity or amount of credit in the system. This is equivalent to
reducing aggregate demand for the goods and services in the economy. (Yes, you
heard right; an increase in the money supply increases
the aggregate demand for goods and
services by businesses and consumers.)
Raising
interest rates is a contractionary policy decision. It is designed to
slow down the economy, reducing output and employment, and raising the
equilibrium prices of goods and services in the economy. Why would the
Fed choose to contract an already anemic economy? To head off inflation,
which has its own set of insidious costs and distortions that significantly
hurt the economy.
The
Fed has always had to tread a very fine line between increasing the money
supply enough in the short run to minimize the depth and length of a recession,
but not increasing the money supply so much that it creates inflation in the
longer run. Excessive money growth is what causes inflation. And
over the last two years, the U.S. has witnessed a record-shattering increase in
the money supply as policymakers struggled to deal with an unprecedented financial
crisis.
I
have been saying for months that this behemoth money supply would
inevitably lead to significant inflation unless steps were taken to shrink it.
I believe the Fed has now begun to take those steps.
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