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Posted: February 01, 2009

Federal Reserve aims to preserve system, curb pain

The economist

Tucker Hart Adams

What is the Federal Reserve trying to accomplish? To prevent the implosion of the international financial system to lessen the depth and severity of the recession.

With a little luck, the first has been accomplished, although things are still fragile. We’ll never know for sure about the second, since there is no way to know what the alternative was. The Fed has three primary tools at its disposal:

•  Buying and selling government bonds in the open market, just as you and I do when we call our broker to purchase or sell a Treasury bond. This is the most important and frequently used tool.
•  Making loans at the discount window and setting the appropriate interest rate (the discount rate). Until recently, this was limited to commercial banks but was extended to investment banks during the financial crisis. Banks generally borrow when they run short of cash (a black mark against them) and for seasonal needs (e.g., banks in agricultural communities that have high loan demand in the spring and deposits coming in during the fall), which is OK.
•  Changing within limits set by Congress the reserve requirement, the percentage of consumer and business deposits that commercial banks must in turn deposit with the Fed. When we make a deposit into our bank account, most of that money is loaned out to other businesses or consumers, but about 10 percent must be held on deposit at the Fed. Until October 2008, no interest was paid on these accounts.
•  In addition, the Fed can use moral suasion or jawboning. If the Fed isn’t happy with what banks are doing, they are called in for a heart-to-heart talk.  It is also responsible for 33 separate regulatory activities, such as bank capital requirements and interest paid on member bank deposits.

In normal times, the Fed focuses on inflation and unemployment.  It uses open market operations to keep overall price increases low and the economy growing at a rate that provides jobs. It doesn’t try to control asset bubbles or the exchange rate, although it certainly pays attention to such things. When inflation starts to increase, usually because the economy is strong and demand for goods and services is pushing up their price, the Fed will sell Treasury securities from its portfolio. This reduces the amount of money circulating through the economy, capping price increases but often pushing us into a recession. The Fed has “taken away the punch bowl” just as the party was getting going.

When unemployment begins to rise, the Fed does the opposite. It buys Treasury securities from the public, “printing” new money (actually, it is all done electronically) to pay for them.  Commercial banks, where this money is deposited, can lend the 90 percent they don’t have to hold as reserves. It is re-deposited at another bank (for example, a consumer borrows money to purchase a car and writes a check to an auto dealership, which then deposits it to its bank account), which can loan out 90 percent. This happens again and again. Thus, the original new money the Fed created is multiplied up to nine times, with a 10 percent reserve requirement.

When loans began to default 18 months ago and banks needed liquidity, the Fed conducted extensive open market operations, along with making new types of loans at the discount window.  But the money multiplier didn’t take effect because banks didn’t loan this new money. Rather, they used it to increase their capital ratios and as a hedge against unexpected withdrawals of deposits.  So more and more liquidity has been poured into the system, literally trillions of dollars, but consumers and businesses aren’t using it to buy homes and cars or expand capacity and jobs, even though interest rates are very low. When banks believe borrowers will be able to repay their loans, they will start lending again. The money multiplier will come back into play, and the potential for inflation is enormous.  But we don’t have to worry about that for a couple of years. Unfortunately!

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Tucker Hart Adams, president of the Adams Group, monitored and analyzed the Colorado economy for 30 years. She can be reached via her website, coloradoeconomy.com.

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Readers Respond

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