Episode 3
Episode summary
The Federal Reserve sure is in the news a lot. But what is it exactly? What does it do and why? How does it affect regular people and businesses? Gusto’s Lead Economist, Liz Wilke, explains.
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Transcript
Liz Wilke (00:00:00) – Hi, I’m Liz Wilke, and this is the Gustonomics Podcast. Each week, I bring you about 10 minutes of economics knowledge so you can be more informed, use the information in your business or work, or maybe just impress your friends at the bar. Whatever brings you here, thanks for checking out the podcast. This week, I’m talking about the F word. For economists, that’s the Fed. Long name, Federal Reserve Bank of the United States. The Fed’s actions influence a lot about the economy and, by extension, the decisions of people in the economy.
Liz Wilke (00:00:34) – But not very many people know what it actually does or how it does it. In a poll last year, 21% of American adults said that they knew nothing at all about the Fed. And another 33% said that they don’t know very much. So by the end of this episode, my hope is that you’ll count yourself among the 46% of Americans who feel more comfortable in their knowledge about the Fed. So let’s start with, what is the Federal Reserve? Well, it’s a bank. But it’s not too easy to think about it like a regular bank that you would use or I would use.
Liz Wilke (00:01:09) – So I’d rather talk about what the Fed does and how it does it. I’ll note here that the Federal Reserve does a lot of things that I’m not going to talk about in this episode. What I’m focused on today is actually inflation, interest rates, and employment, which is all the stuff that often gets talked about in the news.
News clip (00:01:27) – The Federal Reserve is set to meet once again this week in its ongoing fight to combat inflation.
Liz Wilke (00:01:32) – Broadly, the Fed is supposed to help ensure a stable and prosperous economy. Specifically, the Fed is supposed to pursue two goals, full employment and low inflation. OK, so full employment isn’t where nobody is unemployed. But it’s instead where everybody who wants a job and can work can get a job. And low inflation is currently defined by the Fed as 2% per year. It can be a little higher or a little lower, but that’s the Fed’s long-term goal. Great. So that’s what the Fed is supposed to do. How does it do it?
Liz Wilke (00:02:09) – Basically, by affecting how much money there is in the economy. All right. So when there’s a lot of money in the economy, the price of money, which is actually the interest rate, goes down. That makes it cheaper for businesses to finance investments and cheaper for consumers to finance big purchases, like houses, cars, very expensive home entertainment systems, the essentials. All this spending creates demand for workers and jobs to produce all that stuff, which gives the economy a boost towards full employment.
Liz Wilke (00:02:43) – But if all that spending is giving workers more money to spend, that can push up the price of things they buy if businesses aren’t making more things available to keep up with that surge in demand. And that’s how you get inflation. So on the flip side, when there’s less money in the economy, the price of money, again, that’s the interest rate, goes up. And that makes it more expensive to borrow money to make business investments or for consumers to finance those fancy entertainment systems. So they spend less.
Liz Wilke (00:03:13) – And then businesses stop hiring, or they let people go because there’s no business for them. And that keeps prices low, but it also creates more unemployment. The Fed tries to find the right balance between these two scenarios by keeping a Goldilocks amount of money in the economy, so there’s not too much inflation and there’s not too much unemployment. The Fed doesn’t actually print money to control the money supply. The US Treasury does that. So the Fed has to turn to other ways to manage the amount of money in the economy.
Liz Wilke (00:03:43) – It can do one of four things. It can buy or sell US Treasury bonds. It can make loans to commercial banks. It can change the amount of money banks have to keep on hand. Or it can change its interest rate, which is the thing that you’ve heard all about in the news. I’m going to focus on that last one because that’s what everybody keeps talking about. You might have heard about the Federal Reserve setting interest rates starting from late 2022. It does not set the interest rate that you pay at the bank.
Liz Wilke (00:04:14) – But it does set an interest rate that affects all those other interest rates, one interest rate to rule them all, you might say. And that’s the federal funds rate. The federal funds rate is actually two things, but both are tied to the reserves that banks keep. When you or I make a deposit into a commercial bank, the bank doesn’t put that money in the vault. It loans it out to someone else. But the bank can’t loan all of it out. It has to keep some share of that money in reserve.
Liz Wilke (00:04:44) – Banks that don’t have enough money in reserve at the end of the day have to borrow money from the Federal Reserve in order to have enough reserves to meet the legal requirement. This is one way that the Fed changes the amount of money in the economy. It can raise or lower the amount of reserves that a bank is required to keep on hand. The lower the reserve, the more money banks can make available in the economy. And it charges interest on the money that banks borrow from the Fed to cover the reserve.
Liz Wilke (00:05:14) – So, if that interest rate is very low, banks can borrow real cheaply from the Fed to meet those reserves, and then they can loan out their own money to consumers and businesses instead of keeping it locked away. That’s not actually an issue today, because banks are sitting on about $1.8 trillion worth of excess reserves above the required limit thanks to all that pandemic saving. So they don’t really care about borrowing money from the Fed for that purpose. But the federal funds rate matters for a different reason.
Liz Wilke (00:05:46) – It’s the rate that the Fed will pay to banks who put their extra money with the Fed. So if you’re a commercial bank, you have a choice between loaning out your money to consumers and businesses, or you could just toss all that money over to the Fed and earn the federal funds rate, which is currently north of 5% and completely risk-free. So banks are going to require consumers and businesses to pay them more than what they could get just by putting their money in the federal reserve.
Liz Wilke (00:06:16) – And that drives up the interest rate, which makes it more expensive to invest in finance things. This has the effect of pulling economic activity back and cools down the economy.
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Liz Wilke (00:07:02) – Welcome back. I’m talking about the Fed today, specifically about how the Fed influences the economy through how it sets the federal funds rate. Again, this is what the Fed will pay banks to park their money with the Fed rather than put it in the economy. When the economy is running hot, the Fed tries to slow down the economy by encouraging banks to keep more money with the Fed instead of putting it out into the economy.
Liz Wilke (00:07:27) – And that means implicitly that the Fed is trying to put people out of work because of that relationship I talked about earlier between unemployment and the interest rate. Now, whether you think that’s a good thing or a bad thing probably depends a lot on whether you are one of the people who gets put out of work in a slowing economy. If you’re a business owner, a slowdown is both a good thing and a bad thing. A hot economy is really good for business growth, but high inflation drives up the cost of those things and makes it harder to plan.
Liz Wilke (00:07:59) – So a slowing economy can ease those pressures for businesses, but a rising interest rate makes business financing more expensive. So businesses are going to want to plan to finance more investment out of retained earnings versus credit. And even equity markets where businesses would try to find investors are going to be harder to come by since investors can also get a 5% return or better simply by putting their money with the Federal Reserve. So that’s tough. But we also can’t continue to spend $20 for a hamburger.
Liz Wilke (00:08:30) – Inflation at 4, 5, or 6% per year also isn’t a good thing for business planning. Because if people come to believe that it will continue to be that high, they’ll start planning on it and then the price of everything goes up anyway because suppliers will renegotiate their contracts and workers will ask for more pay and businesses will adjust their prices upwards in the expectation of future inflation. This is something that the Fed really cares about getting under control when it’s trying to address inflation.
Liz Wilke (00:09:00) – One interesting thing in recent times is that even with all the interest rate hikes, the unemployment rate has only budged a little bit. So interest rates are going to be high for a long time, definitely through 2023, probably well into 2024. The Fed is going to take its sweet time before bringing down the interest rate because it sees this really robust labor market that seems to be able to handle a lot of pressure. In other words, the Fed can crank up the volume on inflation without sacrificing its other goal of full employment.
Liz Wilke (00:09:34) – A lot of people on both sides say the Fed is either doing too much or too little about the economy. But here’s the thing. The economy is really complex. And trying to manage such a complex thing with this single tool is a bit like trying to land a jet on a boat using the joystick from the original Nintendo. It’s not the most sophisticated tool, and a lot of variables can influence the outcome. So will the Fed manage to land the economy without causing a recession?
Liz Wilke (00:10:03) – That is the trillion dollar question, and I sure hope the Fed board played a lot of Nintendo as a kid. That’s it for this week’s episode. I hope you learned something new and useful for yourself and your business. Please let us know what you think of the podcast by leaving a review or share it with a friend or colleague who might enjoy it. I’m Liz Wilke. Thanks for listening. See you next week.
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