Interest Rate Signals and a Fork in the Path

We’re talking macroeconomics this week – with a focus on the Federal Reserve (the Fed).

Yesterday I put forth the idea that Fed Chairman Jerome Powell is making monetary policy decisions with fiscal responsibility in mind. This is just a theory… and probably not a popular one.

But thus far the theory has held.

Powell clearly recognizes the need for normalized interest rates. He’s been as direct about this as a Fed Chair can be.

The fact is, an economy cannot survive on a permanent diet of cheap money and the malinvestment it fuels. We need real interest rates to help us make informed calculations about which projects we undertake and which we don’t.

This is how the market economy allocates resources effectively – as Adam Smith pointed out in his The Wealth of Nations.

Smith observed that firms and investors make decisions based on their own profits. Yet an invisible hand seems to promote efficient economic growth from their independent actions.

The key is that firms must be able to compare the expected profits of one project to another. Then they can choose to move forward with the best one. Or they can choose not to move forward at all. In so doing, they are unwittingly allocating resources efficiently on behalf of the entire economy.

Of course, the cost of money is a key factor in assessing profitability. That’s what interest rates are – the cost of borrowing money. They signal whether borrowing is cheap or expensive.

This is why suppressing interest rates is destructive. Doing so makes all kinds of projects and investments look profitable. But only because the cost of financing those projects is cheaper than it should be.

Artificially low rates prompt a wave of borrowing and spending. This creates a short-term economic boom as both firms and investors capitalize on cheap rates.

That’s how we got the idea that cutting rates is akin to stimulating the economy. But it only goes so far. As the debt builds up and the payments come due, the boom fades.

At that point the only way to stimulate any further is to print money and inject it into the economy. Which is exactly what the US government did in 2020 and 2021 with their “stimulus checks”.

But printing money only serves as stimulus for a short time. And as we saw first-hand, it leads to consumer price inflation across the board.

This brings us to a fork in the road…

If we keep pumping new money into the system, consumer prices will skyrocket. If we keep at it, we’ll wreck the economy beyond all recognition.

That’s one path forward.

But if we recognize that the jig is up, we can reverse course. We can normalize interest rates to discourage malinvestment. Then we must allow uneconomical projects and companies to fail. This will clear the way for a real economic recovery… which will ultimately save the financial system.

That’s the other path forward.

The great Austrian economist Ludwig Von Mises spelled out the dilemma in his masterpiece Human Action: A Treatise on Economics. Here’s Mises:

There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

It appears that Jerome Powell understands this. And he chose the path of voluntary abandonment. Of fiscal responsibility.

I say that because Powell’s held firm on his decision to normalize interest rates even with some powerful forces working against him.

Lest we forget, the United Nations (UN) tried to get Powell to abandon course all the way back in October 2022. The UN said that the Fed’s actions were reckless. And it publicly stated that all central banks needed to stop raising rates.  

Powell didn’t flinch.

I’m sure the pressure on Powell will heat up over the coming months. He’s going to face immense pressure to cut rates ahead of the upcoming election season.

This question is – will he hold firm?

And so far we’ve only discussed interest rates. Bank reserve requirements are also a key part of the Fed’s monetary policy. And Powell said something curious about bank reserves on Capitol Hill last week.

More on that tomorrow.

-Joe Withrow

P.S. For a deeper dive on what the Fed is really up to and the most important macroeconomic story of our day, please see my book Beyond the Nest Egg – How to Be Financially Independent Outside of a Broken System.

You can find it on Amazon at: https://www.amazon.com/Beyond-Nest-Egg-Financially-Independent/dp/B0CGG5G6XH