During over four decades of teaching, I’ve enjoyed asking students the following questions in my introductory economics course: “What if you could write a check and never have to deduct the …
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During over four decades of teaching, I’ve enjoyed asking students the following questions in my introductory economics course: “What if you could write a check and never have to deduct the amount from your balance? Wouldn’t that be great? Is there any agency or company that can do that?”
I receive numerous looks of bewilderment from the students. Part of the reason may be because more and more young people are not using checks for payment. At some point I’ll have to figure out a way of updating my questions.
But at least I like to think — many of the looks are originating from a genuine confusion about who or what could get away with writing checks with no tally of their cost. Ultimately, won’t the checks bounce?
Yet wait, is there a legitimate answer to my questions? There is, and it is the Federal Reserve (“Fed” for short), the central bank of the U.S. When the Fed writes checks, it literally creates money. When I give students the answer, many of them want to learn more about the Fed, which was the whole point of my story.
The money-creating ability of the Fed has been the source of controversy ever since the Fed was created a century ago. This is an important debate, but one which I won’t engage in here. One reason is I don’t see this power of the Fed being changed anytime soon.
Instead I want to focus on the current debate over the Fed’s role in managing today’s economy. This is a debate that has involved economists, the media and even the President.
First, I need to give you some background on what I mean by the Fed “managing the economy.” Congress has given the Fed two goals – use its powers to create an economy with strong enough growth to keep unemployment low, but not so strong as to generate higher inflation.
One of the major tools the Fed has to impact the economy is control over a key interest rate – technically called the federal funds rate. When the Fed raises or lowers this rate, other rates in the economy – particularly short-term interest rates – move in the same direction.
Here’s the strategy the Fed uses. When the economy is struggling and unemployment is rising, the Fed lowers its interest rate, which causes other interest rates to also drop. Lower interest rates make it cheaper for businesses and households to borrow. When they borrow more, they also spend more, and more spending creates more jobs and reduces unemployment.
Conversely, when the economy is strong and unemployment is low, continued spending and hiring often can cause prices to rise faster — that is — inflation increases. In this case the Fed will try to “cool” the economy by raising interest rates and curtailing borrowing and spending.
At any point in time, the Fed will evaluate the economy and determine which is the greater threat — unemployment that is too high, or inflation that is beginning to take off. Clearly during the Great Recession (2007-2009) and in the years immediately afterward, high unemployment was the problem. During that time the Fed took the unprecedented action of keeping its key interest rate at zero percent.
Finally, in 2015, the Fed was satisfied the economy was growing and unemployment was falling enough that it could begin raising its key interest rate. One practical reason for this action was — with its key interest rate at zero percent - there would be no room for the Fed to lower rates when the next recession hit. The Fed has systematically increased its interest rate during the last four years, with that rate now standing at 2.5 percent.
This gets us to the current debate. In the past the Fed has signaled it would continue raising its key interest rate, perhaps to at least three percent. However, there has been pushback from many who think interest rates are high enough. These opponents to the Fed’s interest rate policy say there is no sign inflation has accelerated, even with very low unemployment.
Some worry continuing to increase interest rates could slow the economy too much — maybe even to recessionary levels. There’s even a theory that the prospect of still higher interest rates was a major factor behind the big stock market plunge in late 2018.
So what will the Fed do? There are some signs — based on speeches by high Federal Reserve officials — that the Fed will soon pause in its hiking of interest rates. This could be the reason why the stock market has recently rallied. Those who think inflation is not a problem would applaud an interest rate pause.
There are others who think inflation is bound to accelerate, and waiting to raise interest rates will just require bigger rate hikes later.
In the coming months, keep your eyes on the Fed and the moves it makes – or doesn’t make – with interest rates. The Fed will have to decide if pushing interest rates higher, or pausing, is needed. We will have to decide if they are right or wrong!
Mike Walden is a William Neal Reynolds Distinguished Professor and Extension Economist in the Department of Agricultural and Resource Economics at North Carolina State University who teaches and writes on personal finance, economic outlook and public policy.