The Federal Reserve's trickle-down problem

Does the Fed's toolkit only work for the rich now?

The Federal Reserve's annual get-together in Jackson Hole, Wyoming, starts Thursday. This year's theme is "Designing resilient monetary policy frameworks for the future." Which is a fancy way of saying: "Everything we used to do isn't working anymore, so what the hell do we do now?"

The Federal Reserve is a creature created by Congress, and the policy tools it has are defined by the legal charter Congress wrote. Those tools basically boil down to creating money to buy various financial instruments (usually U.S. government debt) from the banking system or sell them back. Different tools can effect short-term interest rates or long-term ones. They can involve standard monetary policy, unconventional monetary policy like quantitative easing, or even paying banks interest on their reserves.

But it all comes back to the simple goal of fiddling with interest rates.

That matters because interest rates, simply put, are the price of money. If you're trying to start a small business, but don't have the upfront capital to get it off the ground, the interest rate is what it costs you to get the money from someone else. Like all other economic trades, it's about supply and demand: When lots of people want money for potential new economic ventures, but there's not much money available, interest rates are high. When the supply of money exceeds the demand for it, interest rates are low.

But this causality can also flow in the opposite direction: If the Fed drives down interest rates, it lowers the hurdle to getting capital. That can open up new demand for money, from people who want to do something but couldn't afford the previous rates. That's really the whole idea behind Fed policy: When we have a recession, the Fed lowers the hurdle, new job creation takes off, and the economy snaps back. When it looks like the economy is overheating and inflation might take off, the Fed raises the hurdle and slows things down.

But that raises the question: What happens if the Fed lowers the hurdle all the way to the ground and... nothing happens? What if interest rates hit zero and stay at zero, and the demand for capital and new job creation doesn't sprint ahead?

That's basically the situation we're in now. The Fed shocked many observers by keeping interest rates at zero for seven years straight and pouring gobs of money into the experimental policy of quantitative easing. Yet while the unemployment rate fell to 4.9 percent, participation in the American labor force remains drastically depressed, and wage growth is still sluggish. The inflation rate, one of the clearest signs the economy is maxing out its ability to employ people, refuses to even reach the Fed's 2 percent target, much less exceed it.

Economists at the Fed and elsewhere regularly estimate interest rates' "sweet spot" — basically, the rate that maximizes employment without creating runaway inflation. That sweet spot has been steadily falling for decades. Since the Great Recession, it has functionally been at zero — or even gone negative.

Until recently, the idea that you could have interest rates at zero for an extended period and the economy would still have trouble sailing out of the doldrums wasn't something that even occurred to (most) of the economics profession. If you've heard economic bigwigs like Larry Summers or Paul Krugman discussing something called "secular stagnation," this is what they're talking about.

It's not obvious what the Fed can do about this. It can try even more quantitative easing, or try to push the limits of what financial instruments its allowed to buy, or even experiment with negative interest rates. But all these tools are trickle-down by nature: Different ways of cajoling banks or rich people with extra cash to pump money into job creation efforts for the rest of us.

If you've lowered the cost of that transaction to zero and those exchanges of capital still aren't happening, what else can you do? The Fed can lower the hurdle, but it can't make people want to jump in the first place. This is why Summers and others are insisting that only a big uptick in the government's willingness to spend and borrow can save us now.

This year at Jackson Hole, a group of activists will be pushing to make the Federal Reserve more responsive to everyday Americans' needs. They want Fed officials to put more emphasis on maximizing employment, but they're also proposing deeper reforms: Make the Fed fully publicly owned (many of its shares are still privately owned), remove members of the banking industry from the Fed's governing boards, increase racial and gender diversity among Fed officials, make the process of selecting Fed officials more transparent, and subject the Fed to annual audits by the Government Accountability Office.

Yet despite its ostensibly aristocratic nature, the Fed spent much of the last decade undertaking a remarkably populist effort to boost the economy, defying its inherent bias to sacrifice jobs in order to control inflation. (Though the activists at Jackson Hole aren't wrong to see the December rate hike as a worrying sign that the Fed is reverting to old habits.) It was the House of Representatives — supposedly our most populist and directly democratic institution — that spent most of those years raging against the Fed's efforts, and demanding spending and deficit cuts that dragged down the economy.

So the main problem isn't that the Fed is biased towards the American elite or even that its toolkit inherently favors the rich (although it does). It's that Congress refuses to act.


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