FOMC Interest Rates and Their Impact on the US Economy: Part 2

Introduction

To me, interest rates and their future direction seems to be obsessively discussed and debated by many investors.  So much so, that I often get the impression that many investors believe that interest rates coupled with Federal Reserve policy are the primary drivers of our economy.  From my perspective, interest rates and Federal Reserve monetary policy are contributing factors to economic growth and stability.  However, I would stop short of considering them of primary importance.

The Most Important Factors of Economic Strength

The true strength of an economy is fundamentally related to its capacity to produce sufficient goods and services in order to meet the needs and wants of its people.  Strong economies are highly productive, and production is the true source of wealth.  In order for an economy to be productive it must possess the resources required to produce goods and services.  In economic terms these are referred to as factors of production.  Under modern economic theory there are four factors of production, they are land, labor, capital and entrepreneurship.

Importantly, the reader should notice that money is not included in that list.  Money is simply a medium of exchange, and as such, it has no intrinsic value in its own right.  Its only value comes from the product (goods and services) that buyers or sellers are willing to accept in exchange for the goods and services they want or are offering.  There is an excellent series on the Federal Reserve Bank of St. Louis website titled “Economic Lowdown Podcast Series” that I highly recommend to readers interested in learning more about how the economy works.  Here’s an excerpt from Episode 2-Factors of Production:

“You will notice that I did not include money as a factor of production. You might ask, isn’t money a type of capital? Money is not capital as economists define capital because it is not a productive resource. While money can be used to buy capital, it is the capital good (things such as machinery and tools) that is used to produce goods and services. When was the last time you saw a carpenter pounding a nail with a five dollar bill or a warehouse foreman lifting a pallet with a 20 dollar bill? Money merely facilitates trade, but it is not in itself a productive resource.”

At this point, the reader might ask what is my point?  This is a good question that deserves a rational response.  My point is that the Federal Reserve’s role and/or mandate deal with the supply of money as a method to maintain economic stability.  In this sense, it is attempting to control the medium of exchange called money; however, money does not directly produce anything.  Instead, it is the vehicle that allows us to divide and share the productivity that our economy produces.  The role of the Federal Reserve was described in Episode 14 of the series cited above titled “Getting Real about Interest Rates” as follows:

“In the United States, the Federal Reserve System has been charged by Congress to maintain price stability and maximum employment. Price stability means a low and stable inflation rate, and the Fed uses monetary policy to achieve this goal.”

“More specifically, the Fed’s goal is to maintain a 2 percent inflation rate over the longer run.

Savers, borrowers, and lenders all benefit when inflation remains low and stable—they can conduct their transactions without having to consider whether a high or rapidly changing inflation rate might impact their finances in real terms.”

However, the reader should also understand that changes in interest rate policy by the Federal Reserve are not analogous to flipping a switch.  The truth is that changes in Federal Reserve policy take time to have an effect or impact on the economy or inflation.  According to a report titled “How does monetary policy affect the US economy?” on the website of the Federal Reserve Bank of San Francisco they had this to say:

“HOW LONG DOES IT TAKE A POLICY ACTION TO AFFECT THE ECONOMY AND INFLATION?

It can take a fairly long time for a monetary policy action to affect the economy and inflation. And the lags can vary a lot, too. For example, the major effects on output can take anywhere from three months to two years. And the effects on inflation tend to involve even longer lags, perhaps one to three years, or more.”

Episode 9 of the series on Economic Education in this article is titled “Functions of Money” found here.

I believe it’s worth a read for anyone that wants to understand more about interest rates and their relationship to the economy.  However, the primary point that I am attempting to get across regarding interest rates is that they affect the money supply more than they do the economy.  On the other hand, this can have a positive or negative long-term effect on the economy relative to the willingness of people to make purchases.

This is why I referred to interest rates as a contributing factor rather than a driver of economic growth.  Furthermore, the effects that changes in interest rates and/or monetary policy have are never immediate as pointed out above.  Therefore, I’m not suggesting that interest rates are not important.  Instead, I’m simply trying to offer a rational perspective of the role that interest rates and Federal Reserve policy play.

Entrepreneurship (Technological Advances)

When I was initially studying economics in the late 1960s, I was originally taught that there were only three factors of production – land, labor and capital.  Today, as previously stated, entrepreneurship has been added and generally accepted as a fourth factor of production.  I bring this up, because I believe that investors’ attention would be better served by focusing more on what truly drives economic growth and strength rather than obsessing with interest rates and/or what the Federal Reserve might do at the next FOMC meeting.

Episode 15 of the Economic Education series I have been quoting titled “Economic Growth” discusses the importance of entrepreneurship and technological advancements and their importance and contribution to economic growth and strength.  This is an area that I believe investors should really be paying attention to and thinking about.  Here is an excerpt from this episode:

“But what specific factors lead to economic growth?

Now, let’s connect what we’ve learned about production with what we’ve learned about growth.

For the economy to grow over time, the market could employ more factors of production—more, land, labor, and capital. But, the quantities of these factors are limited, and they need to be balanced. More inputs don’t necessarily translate into more output. Imagine a tiny restaurant with 50 waitresses all clamoring to take your order—not very productive.

The biggest driver of economic gain—the force that sustains long-term economic growth—is technological progress. Technological progress increases labor productivity—that is, it increases how much work can be done in the same amount of time. Technological progress occurs when an innovation becomes widely used. Innovations include things such as new products, scientific discoveries, and improvements to management and work processes. Going back to our restaurant, how could it increase its productivity? Well, it could have better recipes—that is, better recipes for how the chefs prepare the food and how the customers pay for the food.

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