On Wednesday, Fed chairwoman Janet Yellen raised short-term interest rates by 0.25 percent. It had been near zero since 2008, when the last change on interest rates was made. But why is a very slight rate change at all important? Why did it make the headlines? Is such an event important to all Americans?
With these questions in mind, I turned to local economist Alan Harvey for answers. Harvey is the author of the excellent short book Demand Side Economics: Demand Side Minds—you can read my 171 highlights and 2 notes of the book here—and also the executive director of the website Ideaeconomics.
The biggest economic event of the year is not that the unemployment rate hit its lowest point (5.1 percent) in seven years but the Federal Reserve’s decision to change interest rates for the first time in seven years. Why is this big news?
Harvey: The hoopla behind the quarter-point change is misplaced. For one thing, the Feds did not do it. The market forced them to do it. Because the market had been expecting it for the past year. Every financial house on Wall Street predicted we would have one in March, then June, then July. And so on. The miniscule rise had nothing to do with the real economy, job growth, and so on, but with the trading strategies of these firms. In other words, the raise is meaningless to the real economy.
The traders have their trading strategies set in place before announcements of this kind are made, and so if the Feds had done nothing, it would have caused convulsions in the market. The raise was 'priced in,' as traders put it. What this means is the expected rise in interest rates is already in the price of stocks. So, it has to happen, or there will be losses and confusion. As you can see, this is about money and not actual investments. If we were talking about starting a business or factory, a quarter of a percent would be meaningless. It would not make the news. But this is not about Main Street; it's about Wall Street.
So, in your opinion, this rate change will have little to no impact on the real economy? It's just about valuing and trading financial assets?
Right! The problem is we are in a liquidity trap. What this means is that there's still a lot of uncertainty in the market. No one wants to make big investments anymore. There is no confidence in the future. This is where people like Paul Krugman are wrong. They think that if interest rates are kept low, people will eventually make real investments. But as John Maynard Keynes knew, this only works in a stable economy. Investments occur when there is certainty about things. In the economy we have now, there is no confidence, and so it's all about keeping liquid. [Meaning,] those with money want stocks and bonds. Liquid assets. This is why the economy is stagnant and financial markets are growing.