It came as a surprise to no one, anywhere, that the Fed left interest rates at near zero when the Board of Governors met for its regularly scheduled policy meeting last week.
The twist in the announcement, though, was a hint that the Fed might raise short-term rates and lower monthly bond purchases sooner than it had suggested.
To understand the role of the Fed — and its more than 400 economists — in the post-pandemic economy, start with the observation that the central bank wears several hats.
Depending on your perspective of the marketplace, the Fed’s role can shift. One of the central bank’s jobs is to keep inflation in check. Another is to keep the labor recovery afloat.
A third role is more nebulous, but no less important. Today we discuss what hats the Fed needs to wear to help Wall Street, Main Street and the overall economy.
- The Fed as a thermometer
To fulfill its inflation mandate, the Fed acts like a thermometer, taking the economy’s temperature to see if it’s overheating.
When inflation is low, the Fed easily can stimulate the economy by lowering interest rates. By making it cheaper to borrow, the Fed encourages companies to invest and consumers to spend, activity that keeps our economic engine humming.
But if the economy grows too fast, prices might rise too quickly, leading to uncomfortably hot inflation.
Inflation has increased recently, but from incredibly low levels that were prompted by the deflationary effect of the pandemic, which hit both supply and demand.
Areas of the economy seeing big upward price moves are the same ones that nearly were decimated at the height of the pandemic, such as hotel services and rental cars. Prices likely will slow to more normal growth rates over time once these demand-supply imbalances right themselves.
As long as the inflation heat wave is temporary, the Fed can keep interest rates near zero through next year to keep borrowing costs low and the market flush with liquidity.
The increasingly front-and-center risk is that if inflation growth steepens, the Fed might need to raise interest rates sooner and faster. That could chill the economy just as it’s returning to normal.
2. The Fed as a thermostat
For many market participants, the Fed’s role as a thermometer isn’t enough. Main Street also needs the Fed to work like a thermostat.
Large corporations are able to tap capital markets through arms-length investors to finance operations. Small businesses, on the other hand, tend to rely on personal resources, banks, friends, and family (thank you Aunt Florna Rae!).
The Fed has kept interest rates low, but its monthly habit of buying $120 billion in government bonds during the pandemic has had the effect of lowering borrowing costs even more for Main Street companies and their consumers.
ADP Research Institute’s inaugural Quarterly Small Business @ Work Survey, conducted last month, found that only 4% of businesses reported difficulty accessing credit. One big reason was the government Paycheck Protection Program, which helped struggling employers during the economic shutdown. More than 50% of small businesses with more than 5 employees reported receiving loans or loan forgiveness, our survey found.
At last week’s meeting, Fed governors opened the door to reducing monthly bond purchases. That could lead to an increase in financing costs for Main Street employers just as the Paycheck Protection Program is set to expire.
If liquidity is allowed to dry up, even for a good reason like fending off inflation, small employers could have less access to low-cost cash to fund operations or grow their businesses during the recovery.
3. What the economy needs: The Fed as a Stabilizer
The economic recovery is now well underway and set to grow swiftly in coming months, thanks in no small part to the Federal Reserve’s massive stimulus.
But an economy can’t live off of stimulus alone. That’s like calling sugary cereal a balanced diet. ￼ Eventually, the real economy – consumers, business investment, government spending, and exports – will have to be weaned from monetary stimulus if inflation is to stay in check.
The slowest part of the economy to recover has been payrolls. The job market needs a Fed that doesn’t overreact or underreact to economic conditions, but instead provides stability and balance at a time of unprecedented change.
That might mean keeping rates lower for longer to make growth more inclusive and felt by more Main Street employers, workers, and consumers.
This role is the hardest. It requires the Fed to maintain its independence, credibility and sound judgement even when the data doesn’t line up or gives conflicting and inconsistent signals on the health of the overall economy.
Of course, if the Fed’s job was easy it wouldn’t need 400 economists to get it done.