The United States Federal Reserve - A Question?

Question

Historically, when the "Fed" perceives that the U.S. economy is headed for inflation, they raise the Fed Funds Rate.

What I don't understand is why the Fed still expects that this will have an impact today; when we are no longer the biggest group of consumers in the world?

A few decades ago, the Fed could raise rates and the American people & businesses would borrow less and spend less on goods & services. Americans as the biggest consumers in the world, had the power to drive the prices of goods & services down if they slowed their buying.

However, the people of China and India have MUCH more spending power today and we are ALL now competing to purchase a finite supply of goods (be it oil, lumber or rice).

Wouldn't the the producers of these goods just sell their products to consumers outside the U.S.? If so, it seems that raising the Fed. Funds Rate would do little to bring the prices of goods down and would actually harm an already faltering U.S. economy.

Answer 1

You are missing two variables: 1) a fluctuating currency, and 2) most big-ticket items that people borrow money to buy (namely buildings) cannot be imported/exported.

First, when the Fed raises rates, it leads to a stronger dollar. This is because when the USA has a higher interest rate, foreign people are more likely to buy bonds in dollars. This raises the price of dollars.

Since the price of dollars goes up, it lowers the price of imported goods. This fights domestic inflation because the USA imports many of its goods. Let's use a crazy example: let's say the Fed raises rates by 10%, and so a dollar that was previously 2$/Euro is now 1$/Euro. A Volkswagen previously had a cost of $10,000 Euros. At 2$/Euro, this cost is $20,000. At $1/Euro, this cost is now $10,000. With the strong US dollar, which are caused by the higher US interest rates, the price of imports to go down, which fights inflation.

Simultaneously demand for large-ticket items will go down as well. Most people borrow money to buy large items like cars and houses. The amount of cash they can afford to pay for a major item is based not on the actual price of the house, but on monthly payments.

So when the interest goes up, the amount of money they can borrow for the same monthly payment goes down. Again I will use cars for an example and an extreme movement by the Fed. There are interest tables to give exact numbers, but let's say a person can afford a $10,000, and at current interest rates his payments are $400/month. If you increase the interest rate, his payment will suddenly be $600/month for that same $10,000. This means he cannot afford $10,000. He can still only afford $400/'month, which means he can either buy the same car at, say $8,000 or he can buy a car worth $8,000. Either way, the only car he can afford is $8,000 instead of $10,000, which will put downward pressure on the price of cars.

The same things happens with businesses. When you build a factory, you don't just plop down $1,000,000 to build a factory. Instead you raise funds by borrowing money. If it is more expensive to borrow money (higher interest rates), you can't borrow as much and you can't build as quickly.  Again, this puts a negative pressure on prices and retains inflation.

The reason that real estate transactions are so important is that in general the large-ticket items you buy on credit cannot be sold in another country. A large factory in the USA, for instance, is not going to be bought by a Chinese consumer. Nor is an expensive house. These items that are financed through bonds can only be purchased in the USA. By selling less of these items in the USA, you slow down the economy and reduce inflation.

I will say that you have a very good point - in fact rate changes by the Fed today are not as effective as they once were because of the issues you mention. Many economists think we need to restructure our financial system to accomidate global inputs. However, rate changes are still effective in controlling inflation. If you remember that currency fluctuates with interest rates and that most big-ticket items cannot be traded internationally, you can see how increases in domestic interest rates will put a negative pressure on domestic prices.

Answer 2

you are not missing anything.....you are correct in your analysis.....but the Feds still want us to believe that the strategy still works although its obvious that its an outdated way of fixing the problem.

Answer 3

You hit the nail on the head. The Fed doesn't have the power it used to have because the world is becoming richer and more markets exist than in the US. As such, our consumption no longer drives commodity prices.

The Fed can try to raise rates and see what happens. But if all else fails, it'll be time to cut the money supply. Break out the gasoline and lighter, the fed will be burning money like the devil..