Authored by Thorstein Polleit via The Mises Institute,

“I think we have much more of a Fed problem than we have a problem with anyone else”, said US President Donald J. Trump on 20 November 2018.

While the press, mainstream economists, and bankers cry wolf, the US President hits the nail on its head: The Fed is the source of significant economic and political trouble. By issuing US dollar out of thin air, it sets into motion unsustainable booms, which sooner or later turn into bust.

What is more, the Fed, expanding the US dollar quantity through credit expansion, nurtures the “deep state”: Providing it with the financial means to buy voter consent; to increase its impact on all walks of peoples’ lives; to make possible its aggressive military adventures on a world-wide scale; and to keep alive and kicking its monetary system – that couldn’t survive without an ever deeper state.

Viewed from this perspective, is it not good news that the Fed wants to tighten its policy further? Well, the truth is that Fed interest rate changes do not and cannot solve any problems caused by the Fed’s meddling with interest rates in the first place. By its very nature, monetary policy inevitably creates economic distortions – which appear in the build-up and bursting of speculative frenzies and the notorious boom and bust cycles.

By reviewing how the Fed has been setting interest rates in the past, you might get the impression that things have become ever more problematic. Just consider Figure 1, which shows annual US nominal GDP growth and the Federal Funds Rate in per cent. Eyeballing these two series suggests that the Fed has set its interest rates more or less in line with nominal GDP growth.

The "Interest Rate Gap"

Mainstream economists would not find any fault with such an interest rate setting. They would argue that the central bank should, in principle, increase its interest rate if and when economic growth accelerates, and it should lower borrowing costs once GDP expansion loses steam. (A formalized version of this viewpoint has been made popular by the concept of “Taylor interest rate rules.”)

The really interesting finding, however, comes out in Figure 2: It shows the difference between annual nominal GDP growth and the Fed’s main interest rate in percentage points. Moreover, as we can see, this time series has been drifting upwards: from cycle to cycle, the Fed has allowed the gap between nominal GDP growth and its main refinancing rate to widen. In other words: It appears that the Fed’s policy has become increasingly expansionary.

In this context, we have to remind ourselves what artificial lowering of the market interest rate — and this is what the gap between nominal GDP growth and the Fed’s main refinancing rate represents — does to the economy. For instance, it inflates asset prices. In the case of stocks, expected future profits are discounted with a lower interest rate, thereby increasing their present value and thus stock prices.

Pretty much the same happens with real estate prices. As asset prices go up on the markets, their value as collateral in credit transactions also rises. Borrowing on the part of asset holders becomes economically more attractive. Lenders, encouraged by collateral gaining in value, ease their lending standards. As a result, rising asset prices set into motion a borrowing and lending spree.

Furthermore, artificially suppressed market interest rates encourage consumption at the expense of savings. The economy is then living beyond its means. Initially, output and employment increase. Sooner or later, however, it becomes evident that the “boom” is unsustainable, and that it (other things being equal) inevitably has to turn into “bust”.

To fend off the bust, the central bank prevents the artificially lowered interest rate from rising. In fact, to keep the boom going, the central bank has to push the market interest rate to ever lower levels. This is actually what the Fed has been doing for decades: It has set into motion a boom through pushing down market interest rates, and in times of crises, it has lowered borrowing costs even further.

Once the economy recovered, the Fed has raised interest rates, but only very hesitantly. This may explain why the gap between nominal GDP growth and the Fed’s key interest rate has grown so substantially over time. With the Federal Funds Rate currently standing in a band of between 2.00 and 2.25 per cent, Figure 1 b would suggest that the Fed’s rate hiking spree might be pretty close to an end.

What Should — and Can — Be Done

But as noted earlier, this would by no means bring the problems caused by Fed monetary policy to an end. But what should and could be done? Let us conclude this article with what Murray N. Rothbard has to say about the Fed, the problems it creates, and how an economically sound solution would look like: