Why Does the Federal Reserve Raise Interest Rates?

Federal Reserve

The Federal Reserve and the President of the United States seem to be at odds over the idea of raising interest rates. I’m of the opinion that most people, including many of my fellow Libertarians, don’t really understand the base purpose of the Federal Reserve and the point of increasing interest rates. I’m not an economist by trade but the issue is relatively straight-forward and I thought I’d take a few moments to go over it.

As I said, it’s relatively simple. Pretty much since the beginning of human history there has been something called the business cycle, or in common parlance, the boom-bust cycle. Basically, when times are good and people have plenty of money, they tend to spend it on speculative interests in the hope of gaining much more money. In contrast, when times are not good and money is in short supply, people have a tendency to hoard what they have. These two things exacerbate the business cycle.

Essentially, because people are spending more money on potentially enriching schemes during boom times the bubble goes to extremely high levels before it bursts and creates devastating economic destruction. Once the bust takes hold it is difficult to stop the downward spiral because people are reluctant to borrow money.

The solution created by Alexander Hamilton and the founders was the First Bank of the United States. Its primary idea was to raise interest rates during boom times thus curtailing people’s willingness to borrow money and fuel the boom and to lower interest rates during times of bust to encourage people to take out loans and pull the economy from its collapse.

It did not stop the business cycle altogether and thus its opponents, who felt there was artificial manipulation of the economy at the expense of growth abolished it. The booms and bust then grew much worse and so the Second Bank of the United States was formed with essentially the same goals as the first. Once again, the business cycle continued although with tempered effects because of the policies of the bank. As can be expected, people grew unhappy with the bank because they felt it was impacting the booming economy negatively and so it was abolished.

Immediately thereafter there again began a more virulent series of business cycles until Congress established the Federal Reserve which still exists to this day. As expected, the business cycles continue to be a problem as we have seen recently. One of the things that has happened since President Reagan is that the Federal Reserve has acted more to promote economic growth but not to slow it. This means, naturally that the boom cycle is not properly tempered.

That is the point of the Federal Reserve in their recent raising of interest rates. They desire to slow economic growth to temper the boom section of the business cycle. These actions anger the President of the United States in the midst of that cycle. Politicians desire to brag about the good they have done and lay blame for the bad, but the business cycle is beyond their control. The Federal Reserve cannot stop the cycle, the people who make policy can only hope to temper the catastrophic effects of the inevitable bust.

That is why it is generally considered a bad idea for politicians to dictate policy to the Federal Reserve. Their actions are often, and for good reason, opposite of those wished by the politicians.

Tom Liberman

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