While the Central Bank has made a desperate attempt to cover an economic hole, it risks sinking the entire ship.
After watching endless headlines on rising interest rates, historic inflation, and fears of an upcoming economic recession, a careful analysis of the Federal Reserve (commonly known as “the Fed”)’s actions can explain all the years, decisions, and policy actions that may have contributed to these concerns.
Before discussing the Federal Reserve’s use of quantitative easing & tightening, it’s important to define what it is, how it’s intended to be used, and the unintended consequences that have arisen from its current implementation.
Quantitative easing is a monetary policy approach to stimulate activity in periods of economic downturn–particularly by reducing the interest rate for investments and loans after purchasing debt from financial firms. This practice became prevalent after the 2008 recession, as the scale of the Fed’s operations dramatically increased – resulting in an interest rate of nearly 0%.
When consumer spending decreases, business investments sharply decline, and unemployment rates climb to unhealthy levels for the economy, the central bank of the U.S. buys exorbitant quantities of treasury bonds, mortgage-backed securities, and other financial instruments to inject more money into the economy. When the Fed buys these assets, this gives banks liquid money they can lend to consumers at lower interest. Another point of emphasis is the unique influence the central bank has over the economy, as opposed to an individual bank or financial institution. The Federal Reserve’s operations create a significantly larger ripple effect on the money supply than a singular bank, individual, or institution within the financial sector.
After the Fed undergoes quantitative easing, the intention is to drop the interest rate low enough to stimulate economic activity– the lower the cost of borrowing, the more attractive it becomes. Especially at the early stages of development for any business, accessing capital to build infrastructure, attract employees, and enhance marketing is essential to a company’s long-term growth. Supporters of a low interest rate correlate high investment with high business growth and booming businesses with booming job opportunities and wages. So far, it appears that the Federal Reserve has intended to utilize a consistent, well-calculated approach that is applied only when necessary.
The key point of emphasis for quantitative easing is necessary.
The timeliness, economic context, and extent of the injected money supply are all critical factors that haven’t been taken into adequate consideration.
The pandemic’s aftermath highlighted the Fed’s irresponsible use of quantitative easing. At first, economic activity plummeted as large swaths of the workforce fell ill and state governments ordered people to stay at home. In this sense, it may have been intuitive for the Fed to engage in large-scale quantitative easing in hopes of preventing a prolonged depression – especially after suffering from a 3.46% GDP decline (the largest drop since 1946).
However, this is where making such consequential decisions in isolation, without considering the broader political and economic implications, is bound to create lasting damage to the country’s economic health.
It’s important to recall that the Federal Reserve wasn’t the only actor involved in uplifting the American public out of the 2020 recession. Congress also passed up to $5 trillion in aid to households, businesses, healthcare providers, and local governments in the largest stimulus effort in US history. By January 2021, households had accumulated over $3.93 trillion in savings – nearly three times the yearly average between 2010 and 2019. Furthermore, GDP projections in 2021 were also at their highest since 1984, largely due to restrictions loosening up across the country. Subsequently, consumer demand was expected to skyrocket as consumers prepared to spend their pandemic-era savings.
However, the Federal Reserve remained unresponsive to the changing state of the economy and continued to inject trillions of dollars in circulation through its quantitative easing policy–even while inflation was at its highest rate in 40 years and the economy was rapidly expanding. For context, the number of assets the Federal Reserve bought on its balance sheet increased from roughly $0.9 trillion (2007) to $2 trillion (2008). These trends occurred at the heart of the 2008 financial crisis, which was a major catalyst for quantitative easing policy to emerge. From January 2020 to June 2020, the number climbed from approximately $4 trillion to $7 trillion in assets.
At least within the 2020 time frame, it could be justified that such a drastic decision was necessary because the economy was struggling during the heart of the pandemic. However, the Fed continued to pump another $2 trillion dollars (peaking at $8.96 trillion, the largest the Federal Reserve has ever owned in assets) even when the economy expanded, restrictions were lifted, and households had unprecedented amounts of money that were readily available to spend. While demand was surging, the supply wasn’t able to keep up due to global supply chain disruptions during the pandemic.
All of these variables inevitably created a formula that has pushed up prices, reduced purchasing power, and compromised the standard of living for almost every American: rampant inflation.
As spending was spiraling out of control from the combination of low-interest rates and dollars in circulation, consumers suffered from an inflation rate of 9.1% in June 2022 (the highest rise in prices since the 1980s). After all, the textbook definition of demand-pull inflation is too many dollars chasing too few goods.
While concerns of inflation grew from the irresponsible use of quantitative easing, the central bank has now been exigently reversing its previous course of action– quantitative tightening. The policy action is intuitive within its name, the selling of bonds/securities – reducing the money supply with the intention of raising the interest rates. In addition, the Federal Reserve has also raised the discount rate – which increases the cost for other private banks to borrow from them. Since March 16th, 2022, the Federal Reserve has incrementally hiked up interest rates, totaling 4.83% in April 2023. The aim of this policy shift is to encourage less money and spending circulating throughout the economy, ultimately taming inflation rates.
Forcibly contracting the economy carries its own risks. The cost of borrowing a car, mortgage, or student loan to finance higher education has become significantly more expensive – imposing a reasonable restraint on how much the Federal Reserve should be increasing the interest rate. Interest rate hikes were also a significant reason behind the collapse of Silicon Valley Bank (SVB), a financial institution that predominantly served tech startups with almost $210 billion in assets.
The SVB crisis can also be largely attributed to incredibly poor risk management analysis, as they dumped over three-quarters of their portfolio into long-term investments to take advantage of the temporarily low-interest rates. However, the bonds were sold at a loss because their portfolio was yielding at 1.79% – far less than the 3.9% yield due to the interest rate hikes. As a result, SVB suffered from a $1.8 billion loss, and the bank’s desperation to sell their investments at a loss signaled widespread panic to Venture Capital (VC) firms that funded the companies who deposited their money into the SVB bank. As the VCs feared the bank’s ability to guarantee deposits due to their unstable financing practices, they advised all their startup clients to withdraw all the money that was stored at the bank all at once–resulting in a bank run that caused SVB to become insolvent.
Above all else, the most pressing concern of rising interest rates is triggering an economic recession. The more the Federal Reserve pushes the gas pedal on lowering interest rates, the harder they must slam the brakes. While the Fed attempts to dig everyone out of the mess it created, it may bury the economy even deeper. Higher interest rates lead to higher borrowing costs – reducing loans, investments, and economic spending. Although this may provide hope at mitigating inflation, the Federal Reserve risks manufacturing its own recession. History tends to be on the more pessimistic side: ever since 1961, the Federal Reserve has attempted to raise interest rates to curb inflation in over nine instances. Eight out of nine times, a recession has followed.
It’s important to realize that behind all of the vague concepts surrounding interest rates, quantitative easing, and inflation, it will determine whether or not working-class citizens can afford their mortgage, or accept a loan for college. It will determine whether struggling families can foot the grocery bill, or go hungry for another night. It will determine if there will be available jobs to support children and provide individuals with a sense of belonging and purpose.
Behind each action committed by the names of a few board members on the Federal Reserve, there are millions of businesses, families, and livelihoods on the line. At the very least, their next decision should be carried out with thoughtful deliberation – rather than destructive macroeconomic policy.
Mridul Prasad is a first-year CLEG major in the School of Public Affairs. He is a Staff Writer for the American Agora.
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