What effect does the Fed have on the economy?

Dr. Jekyll Poster from 1880s. Source: Wikimedia

Everyone is obsessed with the Federal Reserve. Whether we picture the Chair as a heroic figure fighting off the forces of darkness, or we see them as the center of a global conspiracy to enact vicious cycles of ruin, or view Fed staff and officers as bureaucrats and technocrats overseeing the banking and monetary system, the Fed is in the middle of a lot of our thinking. Are they Dr. Jekyl, searching for cures? Or Mr. Hyde, performing their dastardly deeds under the cover of night?

The Fed has been around for a long time. Currently, they set interbank interest rates and the buy Treasuries and other debt, all in an attempt to manage inflation and the real economy. Interest rates are a key input when we value our financial assets.

Treasury rates and the economy. Source: Aswath Damodaran

The Fed impacts long-term rates by virtue of its credibility – or lack thereof. If market participants believe that the Chair means what he says, that the Fed will adjust rates to influence inflation – then they have the same impact as the Wizard of Oz. But this cuts both ways. If they don’t deliver on their promises, people see that there’s nothing of significant “behind the curtain.”

Right now, the Fed has power because people believe they have power. For 20 years, from 1960 to 1980, the Fed lost credibility as it allowed inflation to accelerate out of control, crippling the economy. Paul Volker changed that, with his adoption of a radical regime. For the next 20 years, the Fed’s primary task was to quell inflation, and they were successful. Falling long-term rates put a tail-wind behind the stock market. Lower rates meant that the present value of corporate cash flows became greater.

In this new era they afford can’t make the mistakes of the ‘60s and ‘70s but also they can’t be as restrictive as the ‘80s and ‘90s. Chairman Powell has made it clear that he believes that the economy is fundamentally sound, but in light of the Covid crisis, they’re not even “thinking about thinking about” raising rates.

But liquidity is no substitute for solvency. All the easy credit in the world won’t make up for a business that doesn’t have any customers (many restaurants) or that loses money with every service provided (airlines). There are a lot of businesses that can’t make money the way things are now, and that simply don’t’ have the resources to wait the year or so it will take to get back to normal.

Sure, the Fed is part of this picture. But they’re not heroes, and they’re not monsters. They’re not the lead character in this story. At best, they play a supporting role.