Last week the Federal Reserve lowered the interest rate known as the Federal Funds rate. It was the third such reduction in interest rates over the past three months. When most students heard about this cut, they didn't know whether to jump for joy, burst into tears or completely ignore the news and go back to watching college basketball. The answer is that the cut is a critical but logical measure, and constantly affects students whether they're walking through a mall or sitting in an interview.
Before leaping into what these cuts mean, it is helpful to first look at the Fed's objectives and how it attempts to achieve them. The mission of the Fed, which was set by an act of congress in 1978, is to maintain a low rate of inflation while simultaneously providing an environment that leads to robust economic growth and low unemployment.
The Fed's main tool in reaching these dual objectives is its control over the federal funds rate. The federal funds rate is the interest rate on funds that banks borrow overnight from each other. Why would this interest rate that would appear to only affect banks take such a central role in discussions of the economy?
The main reason is that changes in the federal funds rate typically cause changes in other interest rates. If a bank's cost of obtaining loanable funds declines, due to a fall in the federal funds rate, banks usually pass the decrease in costs along to customers, in the form of lower interest rates.
For example, when the federal funds rate falls, interest rates that banks charge firms for loans also fall. Other rates fall as well, including the rates charged for home and business mortgages as well as the rates charged for credit card purchases.
While University students may care about the economy in general, they may still wonder how interest rate cuts and the state of the economy directly affects them. Students who plan to look for a job in the next few years should be the most concerned with the state of the economy.
In a recession, firms not only fire workers, but they are typically very reluctant to hire new workers. Hence students planning to enter the job market may find their prospects much dimmer than graduates who found jobs in the last few years.
Students hoping to land jobs with high tech startup companies will also find that there are more of these jobs when interest rates are lower, since obtaining funds to start these companies is cheaper. Students with debt in the form of negotiable rate student loans will also benefit from the recent fall in interest rates, as the decline in interest rates will lower the amount of interest that needs to be paid.
What else does the Fed hope to accomplish by lowering interest rates? It hopes that lower interest rates will stimulate the economy by encouraging firms to invest more, since the cost of obtaining funds has declined. The Fed also hopes that consumers will want to spend more with lower interest rates.
Consumers would be willing to spend more for two reasons. First, the cost of borrowing, often in the form of credit card interest rates, has fallen. Also, the returns on keeping money in a bank is now lower, so consumers may decide to spend their money now, rather than save it for the future.
Moreover, a lower interest rate means lower mortgage rates which may lead to an increase in the purchase of new homes. The recent cuts in interest rates could spur the interest sensitive construction sector.
Since interest rates and the economy are closely linked, one might wonder what effect these rate changes will have on the economy's future. The theory behind interest rate cuts is that they will stimulate the economy.
But when will the current interest rate cuts start to help the economy, and are these cuts the start of a trend of further interest rate reductions? While economists know that interest rate cuts should be beneficial, they also know that the effects of monetary policy occur with 'long and variable lags' as Nobel prize winner Milton Friedman once wrote.
In other words, it is very difficult to predict when the rate cuts will start to help the economy. This is compounded by the fact that the amount of interest rate cuts needed to revive the economy is unknown, partly because we don't know just how bad the economy really is.
That said, it is likely that the Fed will have to continue to cut interest rates over the next couple of months. In real terms, interest rates are not very low by historical standards, which leaves the Fed plenty of room to continue interest rate cuts to revive the economy. However, such cuts are likely to come slowly, as the Fed is afraid of creating inflation by over-stimulating the economy.
(Christopher Otrok is an Economics Professor.)
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