The fed funds rate affects longer-term rates only indirectly. It is mainly a signal of how expansive or restrictive money supply growth is. If the money supply grows too slowly, it is deflationary, which can slow business activity and aggregate growth in the economy. If it grows too fast, we can end up with inflation.
The Fed is always trying to figure out whether there is too much or too little money in the economy. Every 6 weeks, it meets in Washington to review economic conditions and, if necessary, adjust monetary policy.
Right now, the Fed is unsure of what it should be doing. Its June 25 statement basically said that the odds of inflation and deflation are about equal. But because of slow growth in the economy, it decided to err on the side of deflation, which is why it cut the fed funds rate.
The problem is that monetary policy affects the price level only with a long lag. Also, interest rates are powerfully affected by general economic conditions. If the economy is growing slowly, interest rates will tend to be low because business demand for investment capital will be low. A pickup in economic growth, therefore, will tend to raise rates.
Keep in mind that businesses will not borrow unless they can earn a rate of profit greater than the interest rate. Thus the low level of business borrowing, which has helped keep interest rates down, is partly due to the low level of profit. Low profits are due to slow growth, which means that faster growth and higher profits -- two things everyone wants -- necessarily lead to higher interest rates.
The Bush administration argues that improving prospects for growth are behind the recent interest rate rise, a view supported by private economists, as well. If that is true, then rising rates -- as painful as they may be for bondholders and those seeking mortgages -- are a good thing. It means that businesses perceive better profits down the road and are borrowing more to take advantage of them.
Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.
Be the first to read Bruce Bartlett's column. Sign up today and receive Townhall.com delivered each morning to your inbox.