Thursday, June 26, 2003
Carrots and Sticks
The Fed lowered its federal funds rate by one-quarter point in an effort to encourage banks to lower interest rates. The theory is that by making money cheaper, businesses and consumers will borrow money, make new purchases, and stimulate economic growth.
We must do this now, proponents of rate cuts argue, because we have to be very concerned about deflation, the situation in which economy-wide prices fall. This creates a problem because people will postpone consumption if they know prices will be lower in the future.
Does everybody follow this? People will not buy things now because they know prices will be lower in the future.
What is an interest rate? It is how much one party (a bank) is willing to accept to forego alternative uses of the money it holds, and how much another person (the borrower) is willing to pay to use that money. It is the price of money.
So, if we are worried people will not purchase and invest now because they can get a better deal in the future, then why shouldn’t we expect businesses and consumers do the same thing when it comes to borrowing?
The past three years of recession have been a testament to their willingness to postpone such decisions. Knowing that disgruntled members of the Fed want to lower rates further next quarter makes me want to delay my purchase until next quarter. Deflation is not just a possibility, it's a reality in the market for money. The Fed’s strategy of lowering interest rates has not worked for precisely this reason.
Instead of using the carrot of lower interest rates to stimulate the economy, it is time to use the stick of higher interest rates. Everyone is stalling to get a better deal, but at some point the lender has to walk away from the table. Threaten to raise interest rates, and businesses will stop hemming and hawing and take action.
In fact, there will be such a rush that interest rates will rise further because of the demand increase (new buyers of money will enter the market "to get the last of the great deals"). The psychology will have turned. It seems counter-intuitive, but that's the way it is.
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