Why Does the Fed Lower Interest Rates?

When Alan Greenspan (former U.S. Federal Reserve Bank chairman) lowered the Fed funds rate starting in July 1990, his stated purpose was to “offset the unusual tightening of credit by commercial lenders,” in short, to keep the economy from slipping into a recession. By September 1992, the Fed funds rate had dropped to 3%, where it stayed until February 4 1994. As a result of the low returns available in banks, investors put their money into the stock markets. In December 1996, Greenspan noted the “irrational exuberance” in the markets (a building bubble), and tried to dampen the exuberance by haltingly raising the Fed funds rate (eventually reaching 6.5% in May, 2000—see chart). Finally, with the NASDAQ peaking at 5132.52 on March 10 2000, Greenspan succeeded in bursting the stock market bubble with his higher interest rates.

With the economy heading for a recession, Greenspan once again lowered interest rates. When we consider that the economy was already slowing, and we add to that the effects of the September 11 2001, terrorist attacks, and the following stock market decline of 2002, we begin to see why the Fed lowered interest rates from 6.5% to 1.0% (in 12 increments) between January 3 2001 and June 25 2003. It was to prevent a recession (or pull us out of one that had already begun).

Of course, with interest rates at 1% (their lowest level since 1961), lenders and borrowers alike had to find something to do with such cheap money. Because they were now leery of the stock markets, they put their money into real estate instead (it can’t go bankrupt like a company can). Subsequently, we had a real estate boom and bubble. This time, however, when the bubble burst (starting in 2006), the consequences were somewhat more severe. As the number of borrowers defaulting on their loans rose, banks and brokerages started to suffer capital shortages. This triggered the credit crisis in 2007, with the credit markets seizing up, and the economy once again spiraling down into a recession in 2008.

Currently, the Fed is lowering interest rates (the Fed funds rate is currently 2%) with a vengeance to free up the credit markets and to prevent the United States from slipping into a recession. As interest rates come down, the Fed is clearly building a new bubble. This time, with stocks and real estate unavailable as “flight to quality” assets, the bubble is building in the derivatives markets and commodities—worldwide. Demand for derivatives is rising as a hedge against rising commodities prices—from China to Brazil, from Chile to India, from wheat to silver, from corn to crude oil, commodities prices are rising. Commodity supplies are not keeping up with demand, and inflation is contributing to the price rise, as well.

In the past, when the Fed lowered interest rates to avoid, prevent, or eradicate recessions and to keep the economy on permanent high, it simultaneously created the next bubble. When the bubble led to “irrational exuberance,” the Fed then raised interest rates to dampen demand. This led to the next crisis, which, in turn, caused the Fed to lower interest rates. At some point, without an opportunity for the economy to correct for the mal-effects of the last several credit expansions, the Fed won’t be able to raise interest rates without immediately creating a new economic crisis. At that point, the Fed’s willingness to restrain inflation will be tested once again. Based on the Fed’s recent track record, odds are it will opt to let inflation raise commodities prices to record heights. If that doesn’t create a recession, nothing will. But then, that’s the long-term consequence of inflationomics!

Robert Jackson Smith

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