You Decide: What Will The Fed Do?

By Dr. Mike Walden

During my 43 years of teaching economics at North Carolina State University, my favorite part of the introductory economics class was the topic of the Federal Reserve. I’d open the lecture asking students if they’d like to buy things without deducting any funds from their financial accounts. Heads would nod “yes”. Then I’d follow up by asking if they knew of a person, company or institution that could do that. Perplexed stares signaled “no”.

Happy I now had their attention, I would tell the students there actually is an institution that can buy things without deducting an account. Effectively, the institution does so by printing money.  Its name – the Federal Reserve System, or “Fed” for short.The Fed is the central bank of the country. In this role, the Fed has many important duties, such as supervising banks. 

But the most important power of the Fed is monetary policy. The Fed uses its ability to create money – paper in the old days, digital today – to expand or contract spending in the economy and to raise or lower key interest rates. Using this power, the Fed has the ability to move the $24 trillion national economy.

We can see the Fed at work during the COVID-19 pandemic. A large part of the $6 trillion the federal government has appropriated to help households, businesses and institutions get through the pandemic was financed by the Fed.

How was this done? The federal government issued debt, called Treasury securities, to pay for the various COVID-19 relief programs. The Fed bought large amounts of these Treasury securities by creating more money. Indeed, the nation’s supply of money almost doubled in the past two years.

In effect, the Fed enabled the federal government to rescue the economy from the pandemic.  The statistics show the results. After plunging during the Spring of 2020, the economy came roaring back in the summer and fall. Amazingly, median household income was higher in 2020 than in 2019, and the poverty rate was lower after this aid was included.

Although COVID-19 is still with us, some measures show the economy has fully recovered. Indeed, attention has now turned to issues typically seen in a strong economy, specifically higher inflation rates and tight labor markets.

To contain inflation and labor costs, the Fed would put its current policy in reverse. The Fed would sell Treasury securities and pull money out of the economy, and it would also nudge interest rates higher. 

The current Federal Reserve governing board has indicated it may be ready to turn monetary policy around. This means the Fed would be de-stimulating, or slowing, the economy. While this may be good for containing inflation that can be caused by too much money creation, there’s also the possible downsides of slower job growth and higher unemployment.

This is not a new dilemma for the Fed. Congress has given the Fed two mandates: maintain full employment, but also achieve low inflation. Unfortunately, the two goals don’t necessarily go together. Full employment often leads to a tight labor market and faster rising costs and prices.   To achieve low inflation, sometimes slower economic growth has to be tolerated. The two goals can be reached together, but getting there may be hard.

There’s also the matter of timing. A risk of continuing rapid money creation and low interest rates is that higher inflation rates will become deeply embedded in the economy. Then, lowering those high inflationary expectations becomes tougher and can require the hard medicine of a severe recession.

The country went through this scenario 40 years ago in the early 1980s. Rising inflation rates were left unaddressed for several years, ultimately reaching double-digit annual rates for two straight years. Then, under a new Fed chairperson whose orders were to end rampant inflation, the Fed slammed on the monetary brakes. A deep, multi-year recession resulted with lost jobs and incomes. However, the upside was that high inflation rates disappeared.

There are some economists who fear we are at a similar point to where we were forty years ago.  While much higher than in recent years, today’s annual inflation rate is still half of what it was in the early 1980s. Hence, the goal of reducing inflation to where it was before the recent rise – one percent to two percent annually – is within striking distance. But if the Fed waits too long and inflation continues to spike, then the task – and the cost in jobs and incomes – will be much greater.

The Fed is an amazing institution. That’s why I loved teaching about it to students. The Fed has the ability to change the course of our economic ship, and rather quickly. Right now, the Fed is debating its future course. Its decision will have profound impacts on the entire economy and every individual and business. Paraphrasing an old ad, “when the Fed speaks, we should listen.”  You decide if this is good advice to follow, especially now.

Walden is a William Neal Reynolds Distinguished Professor Emeritus at North Carolina State University.