There’s a Limit to What the Fed Can Do

The U.S. Federal Reserve Bank (the Fed) has three tools with which to influence the U.S. economy: 1. the discount rate, 2. the money supply, and 3. bank reserve requirements. In recent times, whenever there has been a financial crisis, the Fed has either lowered interest rates (to stimulate the economy), or printed more money (to stimulate the economy), or both.

Lowering interest rates.

Of course, there is a limit to how much stimulation an economy can take before it becomes over-stimulated and no longer responds to such stimulation. As the process continues, more and more stimulation is needed to have the same effect. (This is true for any kind of stimulant, whether we’re talking about drugs, coffee, or money inflation.) As the crises occur more frequently (war on drugs, S&L bailout, Long-Term Capital Management bailout, war on terror, war in Afghanistan, wars in Iraq, Katrina catastrophe, sub-prime debacle), the Fed’s stimulation must grow. And because this is an election year in the United States, the Fed will do its best to contain, suppress, and conceal the economy’s problems until 2009. This means that the Fed’s only answer (through the 2008 presidential election) is easily predictable; i.e., to print more money and lower interest rates. It’s just a question of timing and degree.

Obviously, the Fed can’t lower interest rates below zero, but just lowering them a couple of percentage points will encourage people who are still willing and able to borrow (although it can’t force them to borrow more) more to buy stocks, real estate, and/or commodities. In the past, easy money has led to bubbles and a misallocation of resources. There is no reason to believe that a repeat of this practice will do otherwise in the future. In other words, the Fed can create economic bubbles.

Raising interest rates.

Theoretically, the Fed could raise interest rates, but if it does this in an effort to curb inflation, for example, it would surely exacerbate the recession we are currently entering. Such a move would lead to a depression and new management at the Fed. This is not a politically feasible option at this time.

Expanding the money supply.

The Fed can expand the money supply in an attempt to rescue the banking system, despite the inflationary effects this has on the U.S. dollar and its exchange rate. And because the world is on a "dollar standard," the new inflation will be felt world wide. It’s just a matter of time before dollar holders try to spend their dollars in a "flight to value," creating another bubble. China and Japan are holding over $1 trillion in U.S. T-Bonds. Just think about the bubble in commodities that would be created if they sold their T-Bonds (that are becoming worth less) and put their dollars into commodities. Now that would be a bubble!

Not expand the money supply.

As inflation heats up, people anticipate more inflation. They "need" more money to cover their rising costs. An inflationary spiral ensues. As it stands today, the U.S. banking system needs more money. The war in Iraq needs more money. Homeowners need more money. As a way of providing more money, money auctions are now available to a much larger audience than ever before. More money is on its way. It’s the only politically expedient thing to do.

What the Fed can’t do.

Unfortunately, with all the power the Fed has to manipulate the economy, the Fed can’t raise productivity, create wealth, lower taxes, turn a poor credit risk into a good credit risk, raise real standards of living, establish a sound money, or cut government spending—all the things that are needed. In short, it is beyond the Fed to do what is needed. Does this mean we’ve exceeded the Fed’s limit? Perhaps the Fed has outlived its usefulness!?!

Robert Jackson Smith

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