President's Message: Whose Side Is The Federal Reserve On?
Pundits across America took pains in 1994 to level one of their favorite charges against the Federal Reserve: that we favor Wall Street over Main Street. Describing the effects of rising interest rates over the past 12 months, one Fed watcher, William Greider put it this way: "The Federal Reserve's decision-making is politics posing as disinterested economics because the issue of monetary policy is always fundamentally about whose economic interests will be defended and whose will be sacrificed."
As Greider sees it, higher interest rates punish borrowers and reward lenders. Since banks are lenders, tight monetary policy helps them—case closed. Unfortunately, this view of the fallout from higher interest rates—bankers sitting back and enjoying higher rates on loans—oversimplifies what is a complex relationship between monetary policy and bank profits.
It is true, as Greider says, that a rise in interest rates causes additional revenue to flow into bank coffers from higher loan rates. But, in a rising interest rate environment, banks are also forced to pay higher rates to their depositors. Moreover, higher rates can weaken the economy and reduce the likelihood that outstanding loans will be repaid. Higher rates also cause banks to suffer losses on their securities holdings.
My point here is not that rising rates always hurt banks. Rather, it is that Greider's view—higher interest rates make banks happy—is simplistic and misleading. Indeed, in 1994, when banks were supposedly reaping the benefits of higher rates, returns on both assets and equity fell for the banking industry.
Truth is, in some circumstances, sound monetary policy can cause distress on Wall Street, just as it does occasionally on Main Street. When the Fed switched to an inflation-fighting strategy in October 1979, for example, bank stock prices actually fell. Such actions, however, are intended to serve a long-term goal: price stability (see Kevin Kliesen's article, "A Fed Focused on Price Stability: The Benefits of a Single Target"). Over the long haul, achieving price stability will deliver the maximum, sustainable level of growth for the economy, which favors both Wall Street and Main Street. I call that disinterested economics.