If you think about it, economics is basically the study of incentives and behavior. Astronomers study space. Biologists study the structure of flora and fauna. Physicists study matter itself. There is no independent natural phenomena to study in economics. The entire field comprises nothing outside of people and how they interact with each other.
Therefore, if you are a central banker, your entire job is essentially using incentives to try and goad people into doing what you want. You pull levers to incentivize people into being more or less economically active. I'm not telling you anything you don't know, but I think framing it this way casts it in a different light.
All of this is to explain what the Federal Reserve did last week. Narrowly speaking, the Fed's rate-setting committee voted to increase the interest rate it pays on funds that banks park at the Fed overnight. But in doing so, the Fed didn't just raise rates, it changed perceptions, and that changes incentives, and that will change behavior. Our Allissa Kline explored
In normal times, the Fed can pull its levers, control people's expectations, and pretty much get what it wants. After the Crash of 2008 and during the pandemic, for instance, it wanted to incentivize people to go out and do economic'y things, so it slashed interest rates. It made borrowing super cheap. That worked (eventually).
But what we call "the economy" is in a weird place right now. Unemployment is low, but inflation is high. Because of the war with Iran, energy prices are rising, which filters through virtually every single thing both people and businesses do. Interest rates are rising for a variety of reasons, among them the heavy debts already being carried by not just the U.S. government but most developed nations.
For the Fed, controlling the interest it pays on deposits is much easier than controlling people's perceptions. One of the things the Fed did in 2020 was to quite literally tell people it was going to let inflation rise. This may have been rational to Jerome Powell. But the effect of telling people inflation is going to rise tends to be that they believe inflation is going to rise, and then quite rationally change their economic interactions to account for higher prices. It really only takes a few key players raising prices to set off the whole dynamic. The Fed has been trying to get that horse back in the barn ever since.
Higher rates are both good for banks and challenging for them. Higher interest rates of course translate to higher revenue on loans. But it can also hurt the demand for those loans. And it juices competition for deposits. For instance, for a lot of depositors, 4% becomes a line in the sand, according to a report from Credit One Bank. The bank surveyed 1,000 people and found that half of them had moved their money. For most of those, the chance to get a 4% rate on CDs or other savings products was a prime motivator.
And it's not just our central bank raising rates in response to what's going on. Central banks in most developed countries are doing the same thing, and the expectations now are for a string of rate hikes. "A sea-change in market expectations about the [developed market] policy path has taken hold since the start of this year," JPMorgan analyst Bruce Kasman wrote in a research note. The market is now projecting that central banks will raise rates by one full percentage point through the middle of next year.
One problem with that is that the central banks seem to be responding to the market rather than driving it. The yield on the U.S. 10-year Treasury note was moving toward the 5% level before the Fed hiked, and has now crossed it. This is, broadly speaking, what the Fed wants. It wants higher interest rates because in normal times higher rates slow down activity, which slows down inflation.
Read more:
Bitcoin's Overton window of opportunity is closing Maybe Wells Fargo's unions need a blockchain Iran built its own financial system, and has created a cyberfront in the war Fed meetings are about to get really awkward
But as I explained, there is no scientific reason for that to happen. Inflation is the result of people's expectations, not a math equation. If people expect prices will be higher tomorrow, they are going to change their behavior today. Inflation is not, as Milton Friedman argued, a monetary phenomenon; it's a psychological phenomenon.
What the central bank is really trying to manage are people's incentives and behavior, which can be tricky. Kevin Warsh wants people to have some agency in what they do, and that's noble. But he may discover that it's easier to manage monetary policy when you are setting people's expectations rather than responding to them.
