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Why Does the Fed Set Rates, Anyway?


“Fed Boosts Benchmark Interest Rate”

Every now and again we read a headline like that in the nation’s newspapers. And just last week, the Federal Reserve raised a key interest rate a quarter point to prevent, so it says, the reappearance of inflation. Here’s the reasoning: consumer demand is high; employers want to hire more workers; but the labor market is tight, so wages will be bid up; that in turn will cause prices to rise.

Everything about that picture is wrong. And Fed Chairman Alan Greenspan knows it.

The Fed based its move on what is known as the “cost push” theory of inflation: the general price level goes up because the cost of production goes up. It has long been debunked. Rising costs cannot push all prices up. Without higher incomes, the American couldn’t pay higher prices for everything. Since they would have to buy less of some things to pay the higher price for others, some prices would not rise. They might fall.

The deeper fallacy is that costs determine prices. They do not. Businesses cannot simply charge customers the cost of a product plus a comfortable profit margin. Just because a product costs $10 to make doesn’t mean consumers will want to part with the $10 to get it. If the product is not worth the price, they will pass it by. Consumer freedom and entrepreneurship, not costs, determine prices. On the contrary, prices help determine costs. If consumers won’t pay more than $10 for a product, that information is conveyed backward in the production process by influencing business’s demand for the materials that go into that product.

The Fed commits another fallacy: it sees the economy as a great engine. Give it too much throttle and it overheats. Give it too little and it moves sluggishly. The Fed is the wise engineer, knowing when to press the pedal and when to tap the brake.

But that’s a terrible metaphor for the economy. It distorts thinking about economic policy. Far from being an engine, the economy is an unending series of decisions made by individuals. People have plans and objectives, and they venture into the marketplace to realize them. Since they learn from experience, people change those plans often and without notice. Entrepreneurs make profits by correctly anticipating changes and helping people to attain their ends.

Since the economy is nothing like a engine, it can do nothing like overheat. The market is people.

Of course, the general price level can rise. There is such as thing as inflation. But it doesn’t come from us. It comes from the Fed. The only way for all prices to rise is for our money to be depreciated. And the only way for that to happen is for the Fed to pump more of it into circulation. Inflation is the result of the government’s monopoly and discretion over money.

What do to? Depoliticize money. Get it out of the government’s hands. This is not as radical as it seems. Money was not invented by government. It is a natural institution of the market. Free-market money has an honorable history. When societies came close to separating money and state they enjoyed stability and prosperity. Governments take over money not to help us, but to gain power over us. Greenspan knows it because he once wrote about the virtues of gold.

When it comes to money and interest rates, the only thing we have to fear is the Fed itself. In America, of all places, the government should keep hands off.

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    Sheldon Richman is former vice president and editor at The Future of Freedom Foundation and editor of FFF's monthly journal, Future of Freedom. For 15 years he was editor of The Freeman, published by the Foundation for Economic Education in Irvington, New York. He is the author of FFF's award-winning book Separating School & State: How to Liberate America's Families; Your Money or Your Life: Why We Must Abolish the Income Tax; and Tethered Citizens: Time to Repeal the Welfare State. Calling for the abolition, not the reform, of public schooling. Separating School & State has become a landmark book in both libertarian and educational circles. In his column in the Financial Times, Michael Prowse wrote: "I recommend a subversive tract, Separating School & State by Sheldon Richman of the Cato Institute, a Washington think tank... . I also think that Mr. Richman is right to fear that state education undermines personal responsibility..." Sheldon's articles on economic policy, education, civil liberties, American history, foreign policy, and the Middle East have appeared in the Washington Post, Wall Street Journal, American Scholar, Chicago Tribune, USA Today, Washington Times, The American Conservative, Insight, Cato Policy Report, Journal of Economic Development, The Freeman, The World & I, Reason, Washington Report on Middle East Affairs, Middle East Policy, Liberty magazine, and other publications. He is a contributor to the The Concise Encyclopedia of Economics. A former newspaper reporter and senior editor at the Cato Institute and the Institute for Humane Studies, Sheldon is a graduate of Temple University in Philadelphia. He blogs at Free Association. Send him e-mail.