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The Economist: Can the Fed do anything to save our economy?

Tucker Hart Adams //December 6, 2012//

The Economist: Can the Fed do anything to save our economy?

Tucker Hart Adams //December 6, 2012//

It’s been almost two years since I’ve written about the Federal Reserve, quantitative easing and all of that fascinating stuff. (I know, I know, but remember that monetary theory was one of my fields of specialization in graduate school.) It is time to address that topic once more, now that the Fed has announced it will continue to purchase securities and keep short-term interest rates close to zero.

I’m sure you remember that the Fed’s mission is to provide maximum employment and stable prices. And that it has three primary tools with which to do this – open market operations, discount window lending and setting reserve requirements. Of these, open market operations are the most important.

Just in case you’ve forgotten, open market operations are the buying and selling of U.S. government securities in the open market. The Federal Reserve Bank of New York carries out these operations by trading U.S. government and select other securities with 21 designated primary dealers such as J.P. Morgan and Credit Suisse.

The Fed doesn’t actually set interest rates. But since the interest rate moves in the opposite direction of the price of a security, when the Fed buys securities, the price rises and the interest rate falls. When it sells securities, the price falls and the interest rate rises. It’s no different from the market for oil or wheat, except for one detail. When the Fed needs money to purchase securities, it creates it. When it receives money from the sale of securities, it destroys it. That’s a bit of an oversimplification, but generally correct. It’s how the Fed “controls” the money supply.

Usually the Fed focuses on the federal funds rate, which is the interest rate at which depository institutions lend balances to each other overnight. The Federal Open Market Committee establishes the target rate for trading in the federal funds market. If they want lower rates they buy securities, the primary dealers deposit the funds in their commercial bank account, banks have more funds to lend other banks, and the fed funds rate falls.

For many months the target for the fed funds rate has been 0 percent to 0.25 percent, and banks are flush with funds. But, because of the uncertainty in the economy, this money isn’t being loaned, invested in business expansion and creating jobs.

The Fed really can’t target a rate below 0 percent – the bank pays you to borrow money – so they’ve changed their tactics. Now they are buying longer-term securities and different types of securities. The media refers to this as quantitative easing – QE1, QE2, QE3.

I believe the motive behind this policy is quite different from supplying the banking system with funds to lend to businesses and consumers. Rather, by pushing the rate on Treasury notes and bonds to very low levels – frequently below the inflation rate – the Fed is trying to encourage investors to purchase other types of securities such as corporate bonds and stocks. This gets money directly to the companies rather than requiring them to borrow it from banks. Perhaps it will encourage investment and job creation. And, the investor who is now earning a bit more may be encouraged to spend more, reinforcing the job creation cycle.

Some people are worried that all of the money sloshing around the banking system is a recipe for inflation. The Fed now holds $2.6 trillion in its system open market account, and the monetary base has more than tripled in the last two years. What happens when banks start lending all that money and consumers start spending?

The Fed assures us that it has this eventuality under control. It can use a new tool, paying interest on the deposits banks hold at the Fed, to make it more lucrative for the banks not to lend the money. Meanwhile they’ll slowly drain the excess money out of the system through selling their security portfolio, preventing too much money from chasing too few goods. Time will tell. But the economy needs to be growing at a healthy rate before inflation will become an issue – a problem we probably all wish for.