It’s clear now that the federal funds rate will play a major role in the American economy in 2019, even more so than it usually does. It’s also clear that most Americans either don’t understand what the federal funds rate is or simply don’t care to.
The Republican base, in particular, is guilty of this, because they continue to tolerate Trump’s naked attempts to threaten the independence of the Federal Reserve, which, if it needs oversight at all, would be Congress’s responsibility, not the president’s.
Regardless, the mere rumor of rate hikes has been enough to send investors running bear several times since October, which has left the various indexes battered. The reasons for this are varied but indicate an economy more fragile than advertised.
But before we can have a meaningful discussion of federal funds rate policy or the role of the Fed, we need some context, and that first requires understanding how the federal funds rate has been used during periods of growth and decline in the past.
Let’s start by outlining what the federal funds rate is. In simplest terms, the federal funds rate is the interest rate banks charge for overnight loans to one other using their Federal Reserve deposits, and this rate is mandated by the Federal Reserve Board.
The higher the federal funds rate, the more expensive it is for banks and other institutions to borrow money from one another. The lower the federal funds rate, the cheaper it is for banks to borrow money from one another. This works… usually.
There have been some exceptions to this in the past, but understanding those exceptions will ultimately help us understand the “rules” that the Federal Reserve is operating under now, beginning with the period that changed those rules 40 years ago.
Interest Rates under Carter
Jimmy Carter’s presidency had begun with an economy recovering from a recession that began before he took office. Notice that the federal funds rate started at 6% in 1977, then climbed 10 full points from 10% all the way to 20%, twice in 1980.
Two things were happening that weren’t supposed to occur simultaneous. First, inflation was out of control (not hyperinflation, but still bad), which necessitated a high federal funds rate. Second, unemployment was rising, which inflation should have solved.
At the time, most economists still believed that rising prices associated with inflation would motivate producers to hire more workers in order to capitalize on the higher prices with more production, except the exact opposite was happening.
As things continued to become more expensive, thanks largely to the cost push of rising fuel prices, consumers were spending less, because high inflation drove down demand. This drop in demand opened the door for another recession that stifled job growth.
Ultimately, the solution was raising federal funds rates and cutting back on new money going into the market (another function of the Federal Reserve). This drastically decreased liquidity caused inflation to come under control by the early 1980’s.
Interest rates under Reagan
Under Reagan, with the inflation under control, the economy stabilized and, after a brief recession in 1981, recovered, settling down into steady expansion and job growth thanks to low taxes, declining inflation, declining interest rates, and a strong dollar.
The federal funds rate fell from 20% in 1981 to just below 6% in 1986, and it seemed that the tighter monetary policy and relaxing federal funds rate under Federal Reserve Chairman Paul Volker had resolved the run away inflation. All seemed well.
Interest rates under Bush, Sr.
Renewed threats to the oil market resulting from instability in the Middle East again put inflationary pressure on the economy, which forced the Federal Reserve, then in the hands of Alan Greenspan, to raise the federal funds rate to just shy of 10%.
But after resolving the First Gulf War in 1990-1991, the oil supply stabilized, and the cost-push inflation eased, allowing rates to drop back below 6%. Unfortunately, the cost of fuel had done a number on the economy, and recession followed soon after.
To deal with the recession, the federal funds rate was decreased well below 6% and down to 3%, which increased liquidity in the financial markets. These rates remained in place after Bush, Sr. left office in 1993, when the jobs market finally stabilized.
Interest rates under Clinton
The economy was recovering under Clinton, and, with the job market expanding to pre-recession levels, the Federal Reserve raised the federal funds rate rapidly from 3% in early 1994, all the way up to 6% by early 1995. The economy expanded through the 90’s.
Since both inflation and unemployment, still the main economic focuses of the Federal Reserve, seemed well under control, the federal funds rate remained between 5% and 6% for most of Clinton’s presidency, dipping slightly below 5% with the dot com crisis.
Interest rates under Bush, Jr.
The beginning of President Bush, Jr.’s presidency was unusual in that it was the first in a while where the economy was not in deep trouble. The dot com crisis was still ongoing, and tech stocks were trying to find their floor, but the broader market was stable.
Then September 11th, 2001 completely changed the political and economic landscape. In the aftermath of the terror attacks that claimed 2,977 souls, the economy was shocked into a recession. Unemployment rose as the economy struggled to find its footing.
The federal funds rate dropped to below 2% by the end of 2001 and to just 1% in 2003, where it remained until the 3rd quarter of 2004. From there, it rose steadily through 2006, topping 5%. It stayed there until the sub-prime mortgage crisis in 2007-2008.
Interest rates under Obama
The mortgage crisis and resulting deep recession is ultimately what swept Barack Obama into office. Despite attempts by the Bush administration to change mortgage policies in 2006, the American public had decided to hold him responsible for the recession.
The federal funds rate spent the next 8 years at near 0%. Unemployment remained high, inflation was nonexistent, and Obama’s Keynesian kitchen sink stimulus programs accomplished nothing, so the federal funds rate never climbed above 1%.
Interest rates under Trump
The economy was expanding, and the Federal Reserve had already implemented to federal funds rate hikes. As of the publishing of this article, the federal funds rate sits at just 2.5%, having been increased from 2.25% over the vocal objections of the president.
There are some fairly unusual things about the economy in the Trump Era, that are reminiscent, albeit opposite, of the Carter Era. Unemployment seems under control, but labor force participation is actually below where it was during the 1980 recession.
Inflation is nowhere to be seen, despite the federal funds rate being below 3% for over a decade. Trump touts this economy as “the greatest economy in history” but whines like a stuck pig if the Federal Reserve Board even hints at raising rates a quarter point.
So this is where we’re at in America right now. On the one hand, we have Republicans claiming that the economy is doing better than ever. On the other hand, we have history showing us reducing the federal funds rate below 5% is how we deal with recession.
So who are we to believe? The Republicans? Or history? I think the answer is clear, and, if the federal funds rate isn’t going to increase more than once or twice in 2019, that tells us a lot about the real state of the United States economy…
Liberty is For The Win!