Could an interest rate increase lead to lower borrowing costs? It’s all about integrity.
A few weeks ago, I wrote about Kevin Warsh’s new approach to the Federal Reserve in On Rates and the Fed. I ended that article by saying, “We’ll just have to watch and see.”
So, let’s see what happened.
Over the past couple of weeks, the bond market listened to Kevin Warsh, the new Chairman of the Federal Reserve, and responded. It took a leap of faith and decided to believe what Warsh was telling them – that if inflation persisted above the Fed’s 2% goal, he would move to get it back in line. The problem, in my view, is that over the past couple of years, market participants began to doubt that the Federal Reserve would remain truly independent.
The Fed’s dual mandate from Congress is maximum employment and price stability. With a currently stable labor market and “resilient” economy, price stability – reflected in inflation that remains above the Fed’s 2% goal – is the variable that is out of line, and arguably has been for several years.
The Fed’s tool to respond to its mandate, the overnight federal funds rate (Fed Funds), directly and indirectly impacts other interest rates in our economy.
The market did what Kevin Warsh wanted it to do. It focused on the incoming economic data and decided that inflation was too high. As a result, traders pushed interest rates higher, essentially telling the Fed, “If you don’t raise rates, we will.” This is exactly what Kevin Warsh wanted the market to do – focus on the data, think for itself and respond. This past week in particular, it was signaling that it thought the Fed should raise the Fed Funds rate. And then they did.
To make this call, the market had to decide that Warsh was credible. That he would do what he said. And this week, he did not disappoint them. It’s probably too early to say it’s the beginning of a great relationship, but it’s undoubtedly a step in the right direction.
No borrower wants more expensive borrowing rates – not the US government, not corporate borrowers, not mortgagors, nor those with credit card debt. But sometimes you have to go higher in order to ultimately go lower. Once Warsh convinces the market that he’s taking the job seriously and won’t be swayed by outside influences, participants should be relieved. What economies want and need most is an independent and competent Federal Reserve that will respond appropriately and lead world markets with diligence and integrity.
This week, the Fed responded to elevated inflation as Kevin Warsh said it would and moved to deliver price stability. There may be short-term pain, but the Fed is playing the long game to “help businesses and households to prosper.” In time, a credible Fed that is committed to containing inflation can help create the conditions for lower long-term borrowing costs. This is what a credible Fed should do – “think carefully and act wisely” – helping to restore confidence, calm fears, and deliver on it’s mandate with discipline and resolve.
