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Unmasking Interest Rates, Honky-Tonk Style

January 27, 2010 at 12:00 AM EST
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In the latest installment in his series of reports making sense of financial news, Paul Solman explains how interest rates are set, with a little help from economic country musician Merle Hazard.
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TRANSCRIPT

JIM LEHRER: Next: a second economy story, this one about the fine line the Federal Reserve is walking. The Fed announced today it plans to keep interest rates at record low levels of near zero for an extended period of time.

Our economics correspondent, Paul Solman, examines that strategy as part of his continuing reporting on Making Sense of financial news.

JON SHAYNE, investment adviser (singing): As we go through this recession…

PAUL SOLMAN: Investment adviser Jon Shayne under his nom de country, Merle Hazard, on the Federal Reserve’s monetary ministrations to revive the economy:

JON SHAYNE (singing): It’s a mini-Great Depression. Our markets went berserk. The Fed is printing trillions now, but will their efforts work?

PAUL SOLMAN: Will Fed policy, that is, made every six weeks in this room, pull us out of the downturn, so prices, wages and consumers don’t start drooping again? The extreme case it’s looking to avoid, Japan these past 20 years and its so-called great deflation.

MAN: We’re terrible poor, a new class, working poor.

PAUL SOLMAN: Or might the Fed, by printing too much money in order to keep interest rates low and the economy ticking, ultimately be driving us in the very opposite direction, toward inflation? The extreme example of the moment: hyperinflationary Zimbabwe.

WOMAN: By December, you needed hundreds of thousands of dollars to buy bread. By January, a loaf of bread and things like tomatoes were costing millions. By April, it was billions.

PAUL SOLMAN: Merle Hazard puts the Fed’s plight as starkly as possible.

JON SHAYNE (singing): Inflation or deflation? Tell me, if you can, will we become Zimbabwe, or will we be Japan?

PAUL SOLMAN: Now, over the past year or so, the Fed has been far more worried about deflation and depression. So, it’s voted to create more than a trillion’s worth of new money.

BRIAN SACK, executive vice president, Federal Reserve Bank of New York: And this is where it all takes place.

PAUL SOLMAN: The New York Fed’s Brian Sack back in July, doing the bidding of the D.C. Fed, to create as much as it took to get the economy back off the mat.

BRIAN SACK: The directive that the Federal Open Market Committee gave to the trading desk here at the New York Fed was to purchase up to $1.75 trillion.

PAUL SOLMAN: One-point-seven-five trillion which the Fed has since used to buy bonds from banks. They, in return, have been getting electronic money, federal reserves.

Buying or selling bonds is how the Fed actually does its main job, managing interest rates. The more dollars created to buy up bonds, the lower the interest rate the government is forced to pay on the bonds. The lower the interest rate, the easier it is for people and businesses to borrow and spend.

Since the Fed’s digital dollars are hopelessly un-telegenic, we’re stuck with this U.S. Mint footage instead. But the rates have been near zero for a year now, and that has critics like John Taylor issuing a warning.

JOHN TAYLOR, Stanford University: How should the central bank, the Fed in our country, set the interest rate so as to get the best performance possible?

PAUL SOLMAN: In his introductory economics course at Stanford a few weeks ago, John Taylor explained his so-called Taylor rule: a formula which guides the Fed when setting interest rates.

JOHN TAYLOR: And it basically says that, if inflation is rising, they should raise the interest rate; if the economy is going through a recession, they should cut the interest rate, and, more importantly, by how much.

PAUL SOLMAN: The key is those last three words: by how much. Taylor’s rule is an actual equation.

JOHN TAYLOR: Well, R is the federal funds rate. P is the inflation rate. Y is the real GDP gap.

PAUL SOLMAN: It’s a bit of a slog for a news show, but simple in its effect: restraining the Fed from creating too much money when, like now, it keeps interest rates at rock-bottom lows.

So, the problem with the Fed is, yes, you stimulate the economy when it’s in the doldrums, but you can get carried away.

JOHN TAYLOR: Absolutely. And we have. And we saw, in the great inflation period in the ’70s, we got carried away. We just had interest much too low compared to what they would be.

PAUL SOLMAN: That was the era in which Fed Chairman Paul Volcker famously choked off the money supply to hike interest rates and ended the great inflation of the ’70s.

For decades thereafter, claims John Taylor, the Fed had followed a moderate course. Then, suddenly, around the year 2000, the Fed began to deviate, keeping interest rates too low for too long, ending in the crash of ’08.

JOHN TAYLOR: If I were to think about why, after two decades of good performance starting with Volcker, going in through most of Greenspan’s term, why there was a deviation, I think it’s really trying to do too much, if you like. Things were working well, and if you’re doing well, you try to do better.

PAUL SOLMAN: Try to do better by boosting the economy with cheap money, thus setting the stage for the inevitable bust.

JOHN TAYLOR: Busts are terrible. And more the boom gets out of hand, the worse the bust will be.

PAUL SOLMAN: So, it is really true that, the higher you fly, the further you fall?

JOHN TAYLOR: In general.

PAUL SOLMAN: And that, Taylor argues, should be the worry today, that the Fed is again keeping rates too low for too long, fueling new bubbles and a future collapse, this time perhaps an inflationary collapse of the U.S. dollar itself, given all the new dollars out there.

The Fed, of course, has an answer: Don’t be ridiculous. If we raise rates right now, says Fed Chairman Bernanke, we choke off the recovery and head back down toward deflation, depression.

BEN BERNANKE, Federal Reserve Chairman: However, as the recovery strengthens, the time will come when it is appropriate to begin withdrawing the unprecedented monetary stimulus that is helping to support economic activity. For that reason, we have been giving careful thought to our exit strategy. We are confident that we have all the tools necessary to withdraw monetary stimulus in a timely and effective way.

PAUL SOLMAN: As to what the Fed will do next:

UNIDENTIFIED MALE: Any hints, just between us, on where interest rates might go?

BEN BERNANKE: Well, they can’t go much further down.

PAUL SOLMAN: So, is Bernanke right, or John Taylor? In the end, as always for the Fed, it’s the same old question, the same old song.

JON SHAYNE (singing): Inflation or deflation? The choice is looking grim. I wonder what John Maynard Keynes would say if we asked him. Inflation or deflation? Tell me, if you can …

JOHN TAYLOR: … Will we be Zimbabwe, or will we be Japan?

PAUL SOLMAN: The answer the Fed is betting on: neither.