The Federal Reserve Has Forgotten Why They Raise Rates

Why does the Federal Reserve raise rates?  Seems like a basic question.  And I think most will agree they do it to limit an economic expansion from progressing too quickly that it spurs inflation.  Inflation, largely a psychological phenomenon, is hard to reverse once it gets ingrained in society.  Or so they say, whoever they are.

Inflation has a large psychological component to it.  Therefore, raising rates must largely be done for psychological purposes too.  If the public believes prices for goods and services are going up, they jump on the band wagon and also hike prices.  Sounds reasonable.  But then why would raising rates limit or reverse this behavior?  Could the Fed have forgotten why they raise rates?

The Federal Reserve has done their own past studies that show when the public knows what the Federal Reserve is going to do, they plan ahead leaving the impact of Fed policy impotent.  Simply put, if it is known that interest costs will increase, the public will proactively take action to limit their negative impact and try to make it a positive one.

Prior to 2000, when the Fed raised rates with much of the public clueless to Federal Reserve policy, the public would mostly be caught off guard.  The public would psychologically reduce risk or output until their future costs and revenues became clearer.  Economists and traders had to master the art of reading the tea leaves from every Federal Reserve members speeches to decide whether to take or limit risk.  Not knowing for sure what the Federal Reserve would do had a tangible impact on the pace of growth and, therefore, inflation.  It is this uncertainty that regulated the economy and markets from overheating.  Yes, the Fed knew this at one time and now seems blissfully ignorant to why they raise rates.  So, what does the Fed accomplish when they raise rates in a highly transparent fashion?

Raising rates and telegraphing these moves, a failed policy pursued to keep the party of 2004, 2005, 2006 and 2007 going, has a detrimental effect on the perceived goal of keeping inflation in check.  When the public prepares ahead of time for Fed rate increases, they know their interest costs and interest income will be increasing.  Planning for increased interest income is easy.  Simply spend more – you can afford it!  For those that have higher interest costs, knowing these costs are increasing can be managed by raising prices. Sound inflationary?  It is! 

The US government is the world's largest borrower.  When interest rates go up, they have less to spend on political projects.  Looking for other revenue sources, either taxes go up, costs to the public go up with less government support, deficits go up, or a combination of these outcomes.  None of these slow the economy and limit inflation.   No, these are all inflationary forces that keep output on a similar or increasing trajectory accompanied with higher prices for goods, services and employment. 

If the Federal Reserve raises rates too far too fast, costs do increase faster than prices can increase thus leading to spending slowdowns from companies and individuals.  And that's why past Federal Reserve monetary policy would have more frequent but much shallower recessions.  Raising rates with public uncertainty leads to a lack of confidence and slower growth.  It was always a guess if the Fed would raise rates AND by how much.  25 basis point, 50 basis points, 75 basis points… who knew and why stand in front of the Fed and take this risk.  Prior Fed policy with uncertainty certainly had potency.

But the new and improved Fed of the modern age, ignoring advice on rate increases from past Feds, pursues steady, slow, well publicized policies.  This type of rate rise cycle from the Fed leads to greater risk taking, faster growth, more interest income and higher levels of inflation.  The end result will look an awful like 2008 where risks grow uncontrolled trying to make up for, or exploit, transparent Fed policy.  

Are we better off with shallow recessions every two to three years and opaque Fed policy, or a doozy (doozy is a technical term taught in most economic courses) of a recession or depression once every 10 years but have full transparency during the joy ride?  The crisis of 2008 should still be too fresh for everyone and this should be an easy answer.  Fed policy should not bring the financial system to the verge of collapse.  The Fed needs to do some historic soul searching and modify failed monetary policy before we all live through a 2008 monetary policy induced redux.