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Following Federal Reserve follies

Middle class wage stagnation and a widening wealth gap characterize the U.S. economy today.

Our central bank, the Federal Reserve, through its interest rate policies, exacerbates these problems.

Here’s why: Interest rates constitute the most important prices in our economy. The level of interest rates affects, directly or indirectly, every saving and spending decision. Interest rates encourage or discourage current consumption.

High interest rates discourage consumption as interest increases the product cost (for example) of acquiring a home or automobile. Low interest rates do the opposite.

Interest rates also provide incentive or disincentive to save. High interest rates incentivize individuals to refrain from current consumption (save) and defer it to the future. Low interest rates do the opposite.

In another way, interest rates impact our standard of living and its growth — through its effect on aggregate saving.

Savings add to the stock of capital goods (things used to make other things.)

Our standard of living increases when this stock of capital or its productivity increase because we earn more and have more of everything to buy.

Consuming less (and saving more) now provides additional capital to the capital stock, which increases our standard of living in the future. Consuming more now (and saving less) adds less to the capital stock and reduces future growth of our standard of living.

Now consider the Federal Reserve.

Since the mid-1980s, the Fed has worked to artificially drive down long-term interest rates — and succeeded. The Fed also actively manipulates and artificially reduces short term interest rates to near zero — and has kept them there for almost 20 years.

What are the consequences of those actions? Individuals spend more and save less. We add less to the capital stock.

Consequently, our standard of living does not grow as rapidly. This exacerbated the stagnation of middle-class wages. Artificially low interest rates particularly punish those who rely on interest income to pay bills and inflate stock values — further widening the wealth gap.

Individuals borrow more (home mortgages, credit cards, auto loans), adding debt they may not be able to repay.

Businesses also succumb to the allure of artificially low interest rates.

Traditionally, businesses grow their profits by developing and producing new products and services. This activity requires capital to finance the additional factories, warehouses, service centers, transportation services, offices, etc., which all add to the capital stock — which, in turn, increases our standard of living. Artificially low interest rates encourage businesses to borrow money and use it to buy back their own shares, boosting their share price and further enriching remaining shareholders — and enlarging the wealth gap.

But this does nothing for our standard of living as it adds nothing to our capital stock.

So, the Federal Reserve’s policies directly impact interest rate levels — for good or for ill. Since the mid-1980s, in my view, it has been for the latter.

Chris Gable is a retired financial advisor and occasional contributor to the Opinion page. He resides in Altoona.

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