Interest Rates as Policy

The Federal Reserve's primary policy instrument is the federal funds rate -- the interest rate at which banks lend reserves to each other overnight. When the FOMC raises this rate, borrowing costs throughout the economy increase: mortgage rates rise, corporate lending rates increase, credit card rates climb, student loan rates go up. When the FOMC lowers it, the reverse occurs. Through this single instrument, the Fed shapes the cost of virtually every credit transaction in the American economy.

The transmission mechanisms from the federal funds rate to the broader economy are multiple and not fully understood. Higher rates slow spending by increasing the cost of borrowing and reducing the present value of future income streams -- which reduces investment, since investment involves spending now to generate returns later. They also appreciate the dollar (higher rates attract foreign capital seeking higher returns), making US exports more expensive and imports cheaper, which shifts demand from domestic to foreign producers. Higher rates reduce asset prices, since assets are valued as the present value of future cash flows discounted at the interest rate -- lower asset prices reduce the wealth of asset holders, who then spend less.

Each of these channels has distributional implications. Rising rates reduce the cost of borrowing (beneficial for borrowers) but increase returns on savings (beneficial for savers). Since high-income households hold more financial assets and low-income households carry more debt relative to assets, rate increases tend to transfer income from low- to high-income households through the savings-returns channel. Rate increases also disproportionately affect employment in rate-sensitive sectors: construction, manufacturing, and durable goods industries whose investment cycles depend on financing costs -- sectors that employ disproportionately working-class and middle-income workers.

Interest rate changes are never economically neutral. They redistribute income between borrowers and savers, between labor and capital, between domestic producers and importers. The question is never whether to redistribute -- it is in which direction.Adapted from Thomas Palley, From Keynesianism to Neoliberalism (2005)

The Taylor Rule, developed by economist John Taylor in 1993, provides a benchmark for assessing the appropriateness of Federal Reserve interest rate policy. The rule prescribes how the federal funds rate should respond to deviations of inflation from its target and of output from its potential -- raising rates when inflation exceeds target or output exceeds potential, lowering them in the opposite case. Actual Fed policy has sometimes departed substantially from Taylor Rule prescriptions, particularly in the 2002-2006 period when some economists argue rates were kept too low, contributing to the housing bubble.

The Fed's response to the 2008 crisis -- cutting rates to near-zero and maintaining them there for seven years -- represented an unprecedented duration of emergency monetary accommodation. That accommodation supported the recovery but also, as documented in Part V.3, contributed to asset price inflation that disproportionately benefited wealthy households. The distributional consequences of sustained low rates are not captured in the aggregate growth statistics that dominate policy assessments.