by Archie M. Richards, Jr.
August 7, 2006

Why are interest rates rising? Why is the Federal Reserve so much in the news? What's even more important than the Fed? Where are stocks headed? Here are answers:

Inflation: When the amount of money increases faster than the goods and services available to buy, prices throughout the economy rise. Rapid inflation is damaging, especially to low income people living on fixed income.

Money: The green bills and coins we carry around, minted by the Treasury Department, constitute only one-tenth of our money supply. Most U.S. money is in bank deposits, which are created by the Federal Reserve Bank. Here's how the creation works:

• The federal government incurs a deficit. The Treasury Department borrows money to cover it. The creditors receive IOUs, and the government gets the money. None of this is new money.

• The Federal Reserve then buys back some of those IOUs. It pays for them by writing numbers in the bank accounts of the sellers. The IOUs disappear, and the bank accounts contain new money which the sellers can spend as they please.

How Does The Fed Know How Much Money to Create? The decisions are made by the members of the Federal Open Market Committee (FOMC), and they don't know; they guess. It would be better if the FOMC increased the money supply at a steady rate, say, 4 percent a year. But the members prefer to flex their policy-making muscles by winging it from month to month.

The FOMC goes about the matter indirectly. It focuses on interest rates in the money market that has the shortest maturities - fed funds - in which banks lend money to each other on a one-day basis. (Such borrowing is made necessary by other Federal Reserve requirements.)

We're talking about two fed funds rates; the actual rate, set by the banks in each transaction, and the rate the FOMC prefers. When the actual rate is below the desired rate, the Federal Reserve sells some of the Treasurys it has in inventory, pulling money out of the economy and raising the rate. When the actual rate is above the desired rate, the Fed buys Treasurys, putting money into the economy and lowering the rate. The money supply fluctuates a lot from day to day. Over time, the Fed creates more money than it absorbs.

In the late-1990s, the fed funds rate averaged about 5.25 percent. But when the economy weakened in 2001, the Fed cut the rate to only 1 percent, flooding the economy with new money. This raised the specter of high inflation. From 2003 to the present, therefore, the Fed has gradually raised the fed funds rate back to 5.25 percent, trying to restrict the economy enough to stop inflation's increase but without throwing a lot of people out of work.

Will any further increases make the economy decline and create high unemployment? Naah, recessions are not caused by increases in short-term rates. They're caused by increases in long-term rates, which the Fed does not control. Businesses usually borrow long term.

The rate on 10-year Treasuries, now below 5 percent, would have to go considerably higher to bring on a recession. Long-term rates abroad are low as well.

The Key Factor: The Federal Reserve's policies are important, all right. But the most important ingredient in economic health is the level of income-tax rates. President Bush's reduction of rates in 2003 lit a fire under the economy that continues to blaze, despite high energy costs.

Another positive: Courts and legislatures are placing limits on the economic damage caused by tort lawyers.

Stock prices have already fallen, and the decline wasn't too bad. Corporations are bloated with cash and are buying their own stock is record amounts. Corporate insiders, who are usually right, have cut back on selling of their stocks and increased their buying. Investment advisors, who are usually wrong, remain pessimistic. The prospects for stocks are excellent.