What does new monetary policy mean? It depends

Have you ever worried about money? Warning: this is a trick question.

Most people, if they worry about financial matters at all, worry about income, not money. The two are not the same. In spite of the vernacular, you don’t “make money,” unless you have a counterfeiting operation in the basement. You earn income by dragging yourself out of bed and showing up for your job.

Money is a special type of asset, a liquid form of wealth — one that you can spend. Money in an economy is the sum of currency, travelers checks and balances in accounts you can write checks on.

You may not have to worry a whole lot about money, but it’s something our central bank, the Fed, worries about a lot.

Through its monetary policy, the Fed can change the amount of money in the economy, and when it does it affects interest rates. Interest rates affect spending, and spending affects the general level of activity in the economy.

If the Fed creates too much money, we get inflation, or in extreme cases hyperinflation. Too little money can lead to a recession. If the Fed totally screws up, like it did in the early 1930s, we can have a Great Depression. Now that’s something to worry about.

From the beginning of 2001 until last summer, the Fed had been on a binge of buying short-term U.S. government bonds because that’s the way it increases the supply of money and lowers interest rates. When the Fed wrote checks to sellers of those bonds, they deposited the checks in their banks and the money supply rose, because checking accounts are money.

The banks, in turn, used those funds to meet their reserve requirements. If banks have reserves in excess of the amount they need to back their deposits, they can use the excess reserves to acquire assets that earn interest, such as car loans, mortgages, and loans to other banks who are short of reserves.

With more and more reserves in the banking system, the rate that banks charged each other for loans, the Federal Funds Rate, fell from 6.5 percent in November 2000 to 1 percent in the summer of 2003, and stayed at that low rate for a year.

You’re not a bank and you can’t borrow at the Federal Funds Rate, but with lots of reserves in the banking system, rates on adjustable rate mortgages, car loans, and home equity lines of credit fell as well. This was good for borrowers, but bad for people who would have liked to see higher rates on assets like certificates of deposit or short-term U.S. Treasury bonds.

Now the expansionary monetary binge is over.

Rather than buying, the Fed is selling short-term government bonds in the bond market. Buyers are writing checks to the Fed. Deposits and reserves in the banking system are growing less rapidly. The Federal Funds Rate, while still low by historical standards, has more than doubled to 2.25 percent and most economists don’t think the Fed is finished with its latest bout of monetary sobriety. The Fed is due to make another decision on a rate hike this week. What does the new monetary policy mean for you?

Like everything in economics, it depends.

Expect short-term interest rates on borrowing and saving to rise. The rates that came down so drastically since 2001 are heading up.

The Fed has less control over longer-term interest rates, such as 10-year Treasury notes, corporate bonds and fixed-rate mortgages. That’s both a blessing and a curse. Because bond and stock prices usually move in the opposite direction of interest rates, rapid change in these rates could cause a sell-off and losses for long-term investors.

Foreign investors in the U.S., not the Fed, exert the most influence on long-term interest rates. We don’t save enough in this country to finance our large federal government budget and trade deficits, so we must turn to foreign countries for that. If the Japanese, the Chinese or the Europeans become disenchanted with the prospects for U.S. stocks, bonds, and real estate, and pull their money out of U.S. markets, then long-term interest rates will rise, perhaps rapidly and dramatically. That could create widespread losses in those markets, a recession, or both.

Now, that’s something we can join the Fed in worrying about.