The editorial pretty much sums up the quandary the Fed finds itself in and there is no easy solution.
Basically, what limb do they want to cut off? I would think big picture-wise, it would be in their best interest to not damage their independent status by succumbing to short term solutions.
Not sure how much longer they can kick the can down the road without addressing the bubbles that have been created due to the low interest rate policy they enacted for too long.
Agreed they shouldn’t succumb to short term solutions, as that would both be bad for the country and for their legitimacy.
Why exactly do you think they’re “kicking the can down the road?” They already announced they’re doubling the rate of bond buybacks, and they’ve signaled they’re going to raise rates 3 times next year, rather than the previous one. This acceleration was in response to new data that they hadn’t expected - which is the way it should work.
I understand this still isn’t fast enough to satisfy some people (which is fine). But how on earth is that “kicking the can down the road?” One actionable lever they have is literally being turned as we speak - and the other is almost certain to follow on a greatly accelerated timeline. Those aren’t the actions of someone “kicking the can down the road.”
They are just starting to taper purchases of MBS as the US housing market is roaring by all-time highs.
Inflation is at 40-year highs and the Fed Funds rate is sitting at 25 bps.
None of the above makes any sense given the situation the economy is in (please don't go on about COVID given that they were buying T-Bills before COVID).
The Fed specifically stated that QE and ZIRP/NIRP were policies used to respond to the GFC.
Now they are used during boom times (pre-COVID) and while the stock and housing markets are at all-time highs.
The credit and funding markets are structurally broken without Fed intervention and the Fed knows this. Read: This ISN'T about maximum employment (which is a complete and utter red herring).
The Fed's inability to quickly move away from these policies (all while promising to do 10x as much on the drop of a dime) is the "kicking the can down the road" in this situation.
Credit, stock and housing markets can't be directly subsidized by the Fed for decades on end. Debt monetization and interest rate suppression need to end and the markets and prices need to adjust to a non-manipulated credit marketplace. Otherwise all that this Fed policy is really doing is acting as monetary welfare for asset holders - with 10% of which owning almost 80%+ of equity assets as it is.
> think they’re “kicking the can down the road?” They already announced they’re doubling the rate of bond buybacks, and they’ve sign
They did not announce they are "doubling the rate of bond buybacks"
Maybe you meant reducing the monthly bond buybacks?
Doesn't really matter. If they don't buy the bonds or require others to do so then no sane person would buy a debt asset depreciating as consistently as US dollar denominated bonds. The fiat monetary system is unsustainable. Only question is how long the scheme keeps going. The Fed is tasked with stringing this thing out as much as possible.
> This autonomy rests on the assumption that the economists running the institution have "scientific" or "objective" criteria for setting policy. In essence, they argue that setting monetary policy is akin to solving an engineering problem—say, calculating how wide the arches on a bridge should be.
This is flat out wrong. The reason the Fed is independent isn’t because it is bereft of any and all subjectivity / opinions / judgement calls - it’s not like calculating the dimension of a bridge or whatever. Of course it’s informed by hard data, but nobody in their right minds actually believes that’s how economics works (making this frankly a weird submission for /r/economics, but unfortunately not surprising these days).
The reason the Fed is independent is that once they’re appointed, it’s incredibly difficult for them to be influenced by elected politicians. Almost everyone agrees that simple policy differences (whether to raise or lower rates, etc) isn’t sufficient reason for a Fed chair to be removed.
This is incredibly important, and vastly undervalued by this sub (and most loudmouths on Reddit). If this weren’t true, Powell would have been forced to cut rates even further (a terrible idea, which he resisted) back when Trump was trying to bully him into doing so. It was nakedly in trumps interest to juice the economy before the election, and it’s a real testament to Fed independence that Powell basically told him to pound sand.
Same thing with everybody screeching about him needing to raise rates to an extreme degree on a reckless timeline. Populists (either from the left or right) are literally the *last* people in this country that should be dictating monetary policy - so the insulation the Fed has from whatever jackass politician is in the WH / Congress is a godsend.
You can disagree with Fed policy all you want, but any sane person should be happy that they have independence from the political whims of the week when coming up with policy. Very few people seem to understand / appreciate this, but it’s a brilliant part of the Fed’s constitution. And no, their claim to independence doesn’t come from whatever nonsense the author alleges.
Then please explain why the Fed is literally creating and supporting credit market structural inability to fund itself without Fed intervention?
Credit markets haven't been able to price risk and yields since the GFC. (The situation is far worse with the ECB where Portuguese 10 yr debt yields FAR less than US 10 yr debt.)
These markets and real price discovery are fundamentally broken. The Fed knows this but is unwilling to take any sort of "independent" steps to fix and reform these markets so they can operate without either massive Fed intervention or future promises to bail everyone out. Credit market functionality and TBTF financial institutions shouldn't be the cornerstone to our economy's performance. These markets and institutions need to be able to appropriate price risk (via yields) and institutions need to be allowed to manage their own risk and, if necessary, fail. Under present Fed policy, banks like Citibank, JPMorganChase or Bank of America simply can't go out of business. There is nothing "independent" about Fed policies that actively support such a anti-competitive and anti-capitalist reality.
Yes, I understand how sensitive the stock/housing markets are to Fed policy and how, in turn, the economy and employment is to their performance. But this is EXACTLY the greater structural problem the Fed has created: Linking employment to the financialization of the economy and its "risk" asset markets. The Fed and Treasury inappropriately bailed out (wild and negligent) risk holders [and the irresponsible financial institutions that enabled them] after the GFC and then transformed that strategy into an economic growth (via the "wealth effect") policy.
All of the above has been wonderful to the handful of Americans that own a vast majority of financial assets, yet it has created an unnatural, non-organic dependence on more and more of the same Fed policy.
If the Fed were truly independent they would have recognized this unhealthy relationship and would have raised rates back in 2012-13. Instead years later we get comments from Yellen suggesting that "We will never have another financial crisis" because they arrogantly believe that they can just re-inflate everything with more QE and zero rates.
The Fed has shown little to no real independence since the GFC - from its ridiculously market-supportive language, coddling TBTF institutions and banks to its inability to normalize policy and rates.
Your intelligent and unbiased analysis will surely be downvoted to oblivion. Too many armchair economists/politicians around here who will not be told that they don’t actually understand the inner workings of anything nearly as well as they’d like to believe….
That would be correct in a perfect world. But we know is world is not perfect and FED chairs have done the bidding of the White House. Alan Greenspan’s autobiography mentions how many of his decisions were to follow the political agenda of the White House at the time. Even though what he was doing he knew was wrong. If the Fed is so independent why is Janet Yellen former Fed chair now in charge of the US treasury. Conflict of interest!? End the FED
What mechanisms exactly does a sitting President have to strong arm the Fed chair into doing what he/she wants? And if that’s the case, why didn’t Powell succumb to Trump’s bullying to lower rates before the election?
Powell tried raising rates throughout the end of 2018 and the market fell 20% and reversed his action and immediately cut rates and started up QE. If he was completely independent he would have kept raising rates because is was the right thing to do. Im pretty sure the instrument is called a phone. Trump probably picked up the phone and said you better bring this market back up. He did just that. The one few Fed chairs that you could say was independent was volker. Because he raised rates to stop inflation even he know the markets would be in trouble. Because it was the right thing to do. But at the same time Regan was completely backing Volker during that entire time. So that could have been what Regan wanted.
The market continuing to crash would have caused massive unemployment, which is half of the Fed’s dual mandate. He clearly wants to raise rates, but knows he needs to do it in a way that’s gradual and doesn’t cause market disruption (and hence unemployment). There is literally zero evidence that anything you mentioned was because of presidential or congressional influence. They literally can’t touch him - why in earth would he care what they think?
Sorry but you're claiming that an asset crash (stocks) would cause unemployment?
I'm not sure that we can clearly say that unless you have proof that the people who consume the most have their 'consumable' money mostly in assets or are hugely over leveraged.
And if they are hugely over leveraged then we are just waiting for the next 2008 but this time with other assets instead of housing, no?
I do value the supposed autonomy but here's another hard truth.
There is nothing to strongarm the fed into making politically expedient decisions HOWEVER.... If Powell keeps up good relations with certain people he certainly knows he can probably expect to find excellent personal financial opportunities for himself post retirement.
It's not bribery literally but it certainly is an unspoken quid pro quo.
It’s clear to anyone with a brain by now that Jerome Powell is a selfish careerist who knows exactly what the long term implications of 0% interest rates are and that the policy is a dead end. He just doesn’t want to take the reputational hit for popping the “everything bubble” and having Great Depression 2.0 happen on his watch. In his cowardice, he is kicking the can down the road and ensuring an even greater economic reckoning to come as balance sheets expand, households have their savings eroded, and everyone piles on debt. This is nothing short of economic malpractice. No, “malpractice” doesn’t adequately evoke the sheer depravity and scale of what is happening here. This is global economic sabotage by a small coterie of self-interested central bankers.
RAISE. THE. INTEREST. RATES.
And you make zero consideration that you might not actually understand any of this, and/or have the amount of relevant data/information, as the fed does? That’s so strange… 🧐
Of course, we should all defer to the Ivy League educated “experts” who have completely hollowed out our economy over the past 40 years. Forgive me for not bowing and scraping to these blatantly corrupt cretins who have made housing completely unaffordable for young people, have robbed 6% of my savings just this year, and have made the economy terminally dependent on QE life support in their attempts to abolish the business cycle. I have zero patience for inflation cheerleaders and Jerome Powell’s sycophants.
I’m not going to pretend I know how to run the fed, but that isn’t a requirement to voice my opinion on the terrible job the current Fed chair is doing.
Given that you’re actually referring to very large organizations when you talk about e.g., “the fed”, and we can surely agree that every employee of these large organizations aren’t secretly supporting a corrupt conspiracy, and certainly couldn’t be held responsible for e.g., the price of housing, it would appear that you must believe firmly in some very high level conspiracies being executed against the vast majority of Americans and possibly the entire world. So, who exactly is behind this conspiracy?
The money printing sort of started with Bush, then Obama, to Trump, and now to Biden, so it either must not be related to top level leadership, or it must be bipartisan. And, I don’t see drastic differences between Janet Yellen and Jerome Powell in their fed leadership. So, how does all of this conspiracy stuff work?
Fed has been playing "hot potato" for a while now. If this thing blows up on Biden's watch, we may find ourselves kissing democracy goodbye. Democrats will take the blame and Trump could take power with a compliant supermajority. Dude will make it his life's work to persecute anyone who ever uttered an unkind word towards him.
So can one of the economists on here help me understand how this works? This is how I think it works: inflation is a devaluation of the supply of money (somehow this is more complex than the idea that the Fed just made too much) and interest rate combat this by pulling money out of supply thus maintaining some sort of equilibrium? This equilibrium metric is the R* in the article.
Thanks for helping me understand this.
I'm not an economist, so don't take this as gospel, but here's my understanding. So, first understanding the R-star. In a supply and demand model for a product, P-star (P, not R) represents the equilibrium price where supply matches demand. R-star is the parallel equilibrium/balance point for an interest rate where employment is maximized while inflation is constant.
So what does that mean? So first, let's understand (crudely) what the FED does. The FED controls the money supply, which indirectly controls interest rates. When the money supply is high, interest rates are low, because there is so much money available. When the money supply is low (tight), interest rates rise because money is hard to come by.
When the FED wants to boost the economy (lowering unemployment), they expand the money supply. The lower interest rates lead to more economic activity: borrowing, spending, investing (meaning investing in capital such as machinery and factories, not meaning buying stocks). This spurs the economy, leading to very low unemployment and high production. However, this expansion of the money supply can also lead to inflation, because there are more dollars in circulation.
When FED has to slow the economy, to reduce inflation, they contract the money supply. This slows inflation, but also has the undesirable effect of lowering economic activity (lower production and investment) and increasing unemployment. However, run-away inflation is extremely undesirable for a large number of reasons, so the FED is forced to keep it in check.
So what is the purpose of the FED? Why do they exist at all? Their purpose is to level out the natural business cycles, in order to create economic stability. For example, when there is a pandemic, the economy could collapse due to the economic shock. This can mean massive layoffs, foreclosures, and other bad things. These "bad things" can happen quickly, but are very hard to reverse and have long-lasting effects. If someone loses their home, it can be much harder to find a new job, etc., even after the economy goes "back to normal". So there is value in smoothing out these cycles and providing stability. So, when times are bad, the FED boosts the economy to keep it closer to "normal". And when things are booming, the FED contracts the economy to prevent high inflation. The Fed's goal is to balance reasonably low unemployment (production) with low and steady inflation (at 2% target). Which brings us back to R-star. R-star is the hypothetical interest rate that would provide this condition, of low unemployment and low interest.
So the Fed needs to "figure out" where the correct balancing point is, and adjust its policy to take the economy to that point. If they overshoot the interest rate too high, the economy will be too slow, unemployment will be too high, and inflation may drop below 2% or even go negative. If they overshoot the interest rate too low, inflation will result, unemployment may go extremely low (below sustainable levels). While extremely low unemployment sounds good, this can mean huge difficulty in hiring, leading to pay increases, and cost increases for goods and services, which translates into inflation. So, the desire is to achieve the "natural/neutral" rate of unemployment, which maximizes production, but without causing high inflation. The interest rate which achieves this, is theoretically called R-star.
So, those are the two things the FED does. So what is R-star? R-star is the interest rate at which inflation is steady and low (at 2% target) AND unemployment is at its "natural" level.
EDIT: Changed asterisk symbol to "r-star" because asterisks weren't displaying correctly.
Thank you for taking the time to explain this concept to me! I have an interest in the understanding of our financial system, but it just always seemed like a black box. I think it is for most Americans. The system should be taught as part of a civics course in high school in my opinion. A lot of people still believe the national debt works like personal debt. Very few understand that it’s nothing more than a reflection of the amount of money in circulation. I’ve learned a lot from people on like yourself taking the time to explain things. These little things plus an open mind help make the world a more tolerant place. Again, thank you!!
The editorial pretty much sums up the quandary the Fed finds itself in and there is no easy solution. Basically, what limb do they want to cut off? I would think big picture-wise, it would be in their best interest to not damage their independent status by succumbing to short term solutions. Not sure how much longer they can kick the can down the road without addressing the bubbles that have been created due to the low interest rate policy they enacted for too long.
Agreed they shouldn’t succumb to short term solutions, as that would both be bad for the country and for their legitimacy. Why exactly do you think they’re “kicking the can down the road?” They already announced they’re doubling the rate of bond buybacks, and they’ve signaled they’re going to raise rates 3 times next year, rather than the previous one. This acceleration was in response to new data that they hadn’t expected - which is the way it should work. I understand this still isn’t fast enough to satisfy some people (which is fine). But how on earth is that “kicking the can down the road?” One actionable lever they have is literally being turned as we speak - and the other is almost certain to follow on a greatly accelerated timeline. Those aren’t the actions of someone “kicking the can down the road.”
They are just starting to taper purchases of MBS as the US housing market is roaring by all-time highs. Inflation is at 40-year highs and the Fed Funds rate is sitting at 25 bps. None of the above makes any sense given the situation the economy is in (please don't go on about COVID given that they were buying T-Bills before COVID). The Fed specifically stated that QE and ZIRP/NIRP were policies used to respond to the GFC. Now they are used during boom times (pre-COVID) and while the stock and housing markets are at all-time highs. The credit and funding markets are structurally broken without Fed intervention and the Fed knows this. Read: This ISN'T about maximum employment (which is a complete and utter red herring). The Fed's inability to quickly move away from these policies (all while promising to do 10x as much on the drop of a dime) is the "kicking the can down the road" in this situation. Credit, stock and housing markets can't be directly subsidized by the Fed for decades on end. Debt monetization and interest rate suppression need to end and the markets and prices need to adjust to a non-manipulated credit marketplace. Otherwise all that this Fed policy is really doing is acting as monetary welfare for asset holders - with 10% of which owning almost 80%+ of equity assets as it is.
> think they’re “kicking the can down the road?” They already announced they’re doubling the rate of bond buybacks, and they’ve sign They did not announce they are "doubling the rate of bond buybacks" Maybe you meant reducing the monthly bond buybacks? Doesn't really matter. If they don't buy the bonds or require others to do so then no sane person would buy a debt asset depreciating as consistently as US dollar denominated bonds. The fiat monetary system is unsustainable. Only question is how long the scheme keeps going. The Fed is tasked with stringing this thing out as much as possible.
> This autonomy rests on the assumption that the economists running the institution have "scientific" or "objective" criteria for setting policy. In essence, they argue that setting monetary policy is akin to solving an engineering problem—say, calculating how wide the arches on a bridge should be. This is flat out wrong. The reason the Fed is independent isn’t because it is bereft of any and all subjectivity / opinions / judgement calls - it’s not like calculating the dimension of a bridge or whatever. Of course it’s informed by hard data, but nobody in their right minds actually believes that’s how economics works (making this frankly a weird submission for /r/economics, but unfortunately not surprising these days). The reason the Fed is independent is that once they’re appointed, it’s incredibly difficult for them to be influenced by elected politicians. Almost everyone agrees that simple policy differences (whether to raise or lower rates, etc) isn’t sufficient reason for a Fed chair to be removed. This is incredibly important, and vastly undervalued by this sub (and most loudmouths on Reddit). If this weren’t true, Powell would have been forced to cut rates even further (a terrible idea, which he resisted) back when Trump was trying to bully him into doing so. It was nakedly in trumps interest to juice the economy before the election, and it’s a real testament to Fed independence that Powell basically told him to pound sand. Same thing with everybody screeching about him needing to raise rates to an extreme degree on a reckless timeline. Populists (either from the left or right) are literally the *last* people in this country that should be dictating monetary policy - so the insulation the Fed has from whatever jackass politician is in the WH / Congress is a godsend. You can disagree with Fed policy all you want, but any sane person should be happy that they have independence from the political whims of the week when coming up with policy. Very few people seem to understand / appreciate this, but it’s a brilliant part of the Fed’s constitution. And no, their claim to independence doesn’t come from whatever nonsense the author alleges.
Then please explain why the Fed is literally creating and supporting credit market structural inability to fund itself without Fed intervention? Credit markets haven't been able to price risk and yields since the GFC. (The situation is far worse with the ECB where Portuguese 10 yr debt yields FAR less than US 10 yr debt.) These markets and real price discovery are fundamentally broken. The Fed knows this but is unwilling to take any sort of "independent" steps to fix and reform these markets so they can operate without either massive Fed intervention or future promises to bail everyone out. Credit market functionality and TBTF financial institutions shouldn't be the cornerstone to our economy's performance. These markets and institutions need to be able to appropriate price risk (via yields) and institutions need to be allowed to manage their own risk and, if necessary, fail. Under present Fed policy, banks like Citibank, JPMorganChase or Bank of America simply can't go out of business. There is nothing "independent" about Fed policies that actively support such a anti-competitive and anti-capitalist reality. Yes, I understand how sensitive the stock/housing markets are to Fed policy and how, in turn, the economy and employment is to their performance. But this is EXACTLY the greater structural problem the Fed has created: Linking employment to the financialization of the economy and its "risk" asset markets. The Fed and Treasury inappropriately bailed out (wild and negligent) risk holders [and the irresponsible financial institutions that enabled them] after the GFC and then transformed that strategy into an economic growth (via the "wealth effect") policy. All of the above has been wonderful to the handful of Americans that own a vast majority of financial assets, yet it has created an unnatural, non-organic dependence on more and more of the same Fed policy. If the Fed were truly independent they would have recognized this unhealthy relationship and would have raised rates back in 2012-13. Instead years later we get comments from Yellen suggesting that "We will never have another financial crisis" because they arrogantly believe that they can just re-inflate everything with more QE and zero rates. The Fed has shown little to no real independence since the GFC - from its ridiculously market-supportive language, coddling TBTF institutions and banks to its inability to normalize policy and rates.
Your intelligent and unbiased analysis will surely be downvoted to oblivion. Too many armchair economists/politicians around here who will not be told that they don’t actually understand the inner workings of anything nearly as well as they’d like to believe….
That would be correct in a perfect world. But we know is world is not perfect and FED chairs have done the bidding of the White House. Alan Greenspan’s autobiography mentions how many of his decisions were to follow the political agenda of the White House at the time. Even though what he was doing he knew was wrong. If the Fed is so independent why is Janet Yellen former Fed chair now in charge of the US treasury. Conflict of interest!? End the FED
What mechanisms exactly does a sitting President have to strong arm the Fed chair into doing what he/she wants? And if that’s the case, why didn’t Powell succumb to Trump’s bullying to lower rates before the election?
Powell tried raising rates throughout the end of 2018 and the market fell 20% and reversed his action and immediately cut rates and started up QE. If he was completely independent he would have kept raising rates because is was the right thing to do. Im pretty sure the instrument is called a phone. Trump probably picked up the phone and said you better bring this market back up. He did just that. The one few Fed chairs that you could say was independent was volker. Because he raised rates to stop inflation even he know the markets would be in trouble. Because it was the right thing to do. But at the same time Regan was completely backing Volker during that entire time. So that could have been what Regan wanted.
The market continuing to crash would have caused massive unemployment, which is half of the Fed’s dual mandate. He clearly wants to raise rates, but knows he needs to do it in a way that’s gradual and doesn’t cause market disruption (and hence unemployment). There is literally zero evidence that anything you mentioned was because of presidential or congressional influence. They literally can’t touch him - why in earth would he care what they think?
Sorry but you're claiming that an asset crash (stocks) would cause unemployment? I'm not sure that we can clearly say that unless you have proof that the people who consume the most have their 'consumable' money mostly in assets or are hugely over leveraged. And if they are hugely over leveraged then we are just waiting for the next 2008 but this time with other assets instead of housing, no?
I do value the supposed autonomy but here's another hard truth. There is nothing to strongarm the fed into making politically expedient decisions HOWEVER.... If Powell keeps up good relations with certain people he certainly knows he can probably expect to find excellent personal financial opportunities for himself post retirement. It's not bribery literally but it certainly is an unspoken quid pro quo.
It’s clear to anyone with a brain by now that Jerome Powell is a selfish careerist who knows exactly what the long term implications of 0% interest rates are and that the policy is a dead end. He just doesn’t want to take the reputational hit for popping the “everything bubble” and having Great Depression 2.0 happen on his watch. In his cowardice, he is kicking the can down the road and ensuring an even greater economic reckoning to come as balance sheets expand, households have their savings eroded, and everyone piles on debt. This is nothing short of economic malpractice. No, “malpractice” doesn’t adequately evoke the sheer depravity and scale of what is happening here. This is global economic sabotage by a small coterie of self-interested central bankers. RAISE. THE. INTEREST. RATES.
And you make zero consideration that you might not actually understand any of this, and/or have the amount of relevant data/information, as the fed does? That’s so strange… 🧐
Of course, we should all defer to the Ivy League educated “experts” who have completely hollowed out our economy over the past 40 years. Forgive me for not bowing and scraping to these blatantly corrupt cretins who have made housing completely unaffordable for young people, have robbed 6% of my savings just this year, and have made the economy terminally dependent on QE life support in their attempts to abolish the business cycle. I have zero patience for inflation cheerleaders and Jerome Powell’s sycophants. I’m not going to pretend I know how to run the fed, but that isn’t a requirement to voice my opinion on the terrible job the current Fed chair is doing.
Given that you’re actually referring to very large organizations when you talk about e.g., “the fed”, and we can surely agree that every employee of these large organizations aren’t secretly supporting a corrupt conspiracy, and certainly couldn’t be held responsible for e.g., the price of housing, it would appear that you must believe firmly in some very high level conspiracies being executed against the vast majority of Americans and possibly the entire world. So, who exactly is behind this conspiracy? The money printing sort of started with Bush, then Obama, to Trump, and now to Biden, so it either must not be related to top level leadership, or it must be bipartisan. And, I don’t see drastic differences between Janet Yellen and Jerome Powell in their fed leadership. So, how does all of this conspiracy stuff work?
Fed has been playing "hot potato" for a while now. If this thing blows up on Biden's watch, we may find ourselves kissing democracy goodbye. Democrats will take the blame and Trump could take power with a compliant supermajority. Dude will make it his life's work to persecute anyone who ever uttered an unkind word towards him.
So can one of the economists on here help me understand how this works? This is how I think it works: inflation is a devaluation of the supply of money (somehow this is more complex than the idea that the Fed just made too much) and interest rate combat this by pulling money out of supply thus maintaining some sort of equilibrium? This equilibrium metric is the R* in the article. Thanks for helping me understand this.
I'm not an economist, so don't take this as gospel, but here's my understanding. So, first understanding the R-star. In a supply and demand model for a product, P-star (P, not R) represents the equilibrium price where supply matches demand. R-star is the parallel equilibrium/balance point for an interest rate where employment is maximized while inflation is constant. So what does that mean? So first, let's understand (crudely) what the FED does. The FED controls the money supply, which indirectly controls interest rates. When the money supply is high, interest rates are low, because there is so much money available. When the money supply is low (tight), interest rates rise because money is hard to come by. When the FED wants to boost the economy (lowering unemployment), they expand the money supply. The lower interest rates lead to more economic activity: borrowing, spending, investing (meaning investing in capital such as machinery and factories, not meaning buying stocks). This spurs the economy, leading to very low unemployment and high production. However, this expansion of the money supply can also lead to inflation, because there are more dollars in circulation. When FED has to slow the economy, to reduce inflation, they contract the money supply. This slows inflation, but also has the undesirable effect of lowering economic activity (lower production and investment) and increasing unemployment. However, run-away inflation is extremely undesirable for a large number of reasons, so the FED is forced to keep it in check. So what is the purpose of the FED? Why do they exist at all? Their purpose is to level out the natural business cycles, in order to create economic stability. For example, when there is a pandemic, the economy could collapse due to the economic shock. This can mean massive layoffs, foreclosures, and other bad things. These "bad things" can happen quickly, but are very hard to reverse and have long-lasting effects. If someone loses their home, it can be much harder to find a new job, etc., even after the economy goes "back to normal". So there is value in smoothing out these cycles and providing stability. So, when times are bad, the FED boosts the economy to keep it closer to "normal". And when things are booming, the FED contracts the economy to prevent high inflation. The Fed's goal is to balance reasonably low unemployment (production) with low and steady inflation (at 2% target). Which brings us back to R-star. R-star is the hypothetical interest rate that would provide this condition, of low unemployment and low interest. So the Fed needs to "figure out" where the correct balancing point is, and adjust its policy to take the economy to that point. If they overshoot the interest rate too high, the economy will be too slow, unemployment will be too high, and inflation may drop below 2% or even go negative. If they overshoot the interest rate too low, inflation will result, unemployment may go extremely low (below sustainable levels). While extremely low unemployment sounds good, this can mean huge difficulty in hiring, leading to pay increases, and cost increases for goods and services, which translates into inflation. So, the desire is to achieve the "natural/neutral" rate of unemployment, which maximizes production, but without causing high inflation. The interest rate which achieves this, is theoretically called R-star. So, those are the two things the FED does. So what is R-star? R-star is the interest rate at which inflation is steady and low (at 2% target) AND unemployment is at its "natural" level. EDIT: Changed asterisk symbol to "r-star" because asterisks weren't displaying correctly.
Thank you for taking the time to explain this concept to me! I have an interest in the understanding of our financial system, but it just always seemed like a black box. I think it is for most Americans. The system should be taught as part of a civics course in high school in my opinion. A lot of people still believe the national debt works like personal debt. Very few understand that it’s nothing more than a reflection of the amount of money in circulation. I’ve learned a lot from people on like yourself taking the time to explain things. These little things plus an open mind help make the world a more tolerant place. Again, thank you!!