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Dr. Kalinda Rose Stevenson
Why The Federal Reserve Is Keeping Its Fingers Crossed Under The Streetlight
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On Tuesday, August 5, the Federal Reserve voted to keep the interest rate for banks unchanged. Although I am by no means an expert on the economy and the role of the Federal Reserve, the actions of the Federal Reserve often remind me of that old cartoon about the conversation between Bob and Joe under the streetlamp. Bob sees Joe looking at the sidewalk under the streetlamp and asks:
Bob: “What are you looking for?”
Joe: “My keys.”
Bob: “Did you lose them here?”
Joe: “No, I dropped them over there.”
Bob: “Why are you looking for them here, when you dropped them over there?
Joe: “There’s no light over there.”
The goal of the Fed is to control the money supply to prevent both inflation and recession. It’s easy to think of the Federal Reserve as a giant puppet master in Washington, able to pull the strings of the economy when it goes off track. As powerful as it is, the Federal Reserve is really a one-trick pony, with one major tool. It can raise or lower the interest rates that it charges banks for money.
“The Federal Reserve, confronted with the perils of a slumping economy and rising inflation, has decided for a second straight meeting to leave interest rates unchanged.
“The Fed announced Tuesday that it was keeping its target for the federal funds rate, the interest that banks charge each other on overnight loans, at 2 percent.
“Wall Street seem pleased with the decision. Share prices had been higher most of the day after oil dropped to around $118 a barrel. They gained a little more speed when the announcement came in as expected and the central bank didn’t tip its hand on when it might begin raising rates again. Federal Reserve
The Fed’s problem is that its main policy tool–setting interest rates for the banks–can only address one problem at a time.
To get back to Bob and Joe, the real problem is “over there, but the Fed can’t fix that problem, so it stands under the streetlamp, looking for a solution in the wrong place.
The two big threats facing the economy right now are inflation and recession. What can the Fed do when inflation is not the result of interest rates but the cost of oil? What can the Fed do when recession is not the result of interest rates but a result of the housing, mortgage, and credit crises?
“Federal Reserve Chairman Ben Bernanke and his colleagues are being forced to navigate treacherous waters, trying to keep the economy from plunging into a deep recession while worrying about keeping interest rates so low that they could trigger a dangerous inflation spiral.
“The Fed is really locked in right now. They can’t go forward or backward,” said Sung Won Sohn, an economics professor at the Smith School of Business at California State University Channel Islands. Stuck In Quagmire
What effect does the Fed’s decision to hold the banks’ prime lending rate at 2 percent have on inflation when the primary cause of inflation is oil prices?
Consider what happened in the 1970s, when oil prices shot through the roof and the Federal Reserve raised interest rates. The result was “stagflation,” an era of both inflation and stagnant growth in the economy.
But the most important element in the war against inflation was the Federal Reserve Board, which clamped down hard on the money supply beginning in 1979. By refusing to supply all the money an inflation-ravaged economy wanted, the Fed caused interest rates to rise. As a result, consumer spending and business borrowing slowed abruptly. The economy soon fell into a deep recession. Stagflation in the 1970s
Once again, we have rising inflation, triggered mostly by oil prices, and either the imminent threat or reality of recession as a result of the housing, credit, and mortgage debacles. What is the Federal Reserve doing in response?
“Responding to a severe credit crisis, the Fed last September launched an aggressive effort to cut interest rates. It reduced the funds rate seven times, lowering it from 5.25 percent, where it had been for more than a year, down to 2 percent in April.
“At the Fed’s last meeting on June 24-25, Fed officials passed up the chance to cut rates again. Instead, they signaled growing concerns about inflation pressures that have been made worse this year by surging oil prices, which hit a record high at $147.27 per barrel on July 11. Stuck%20In%20Quagmire %20
“>Stuck In Quagmire
The decision on August 5, 2008 to keep the prime lending rate unchanged is not so much smart strategy as recognition that the Federal Reserve can’t do much to prevent inflation or control recession.
So, will the Fed’s decision help the economy? Wall Street responded favorably, but it is important to note that Wall Street was already responding favorably because oil prices have fallen.
“The oil market also helped soothe some of Wall Street’s worries - crude fell as low as $118 a barrel before settling at $119.17, down $2.24 on the New York Mercantile Exchange. Oil has now fallen $28 from its July 11 high of $147.27 on widening expectations that the slumping U.S. economy will keep curbing consumer demand for gasoline and other petroleum products. Stocks close sharply higher after Fed decision.” Federal Reserve Holds Key Rate
Taken as a whole, the economy is affected by many forces. Many of these forces are far beyond the control of elected officials and the actions of any agency, such as the Federal Reserve. Although the actions of the Federal Reserve are powerful, they are not all-powerful. And so, the Fed makes its decisions under the streetlamp, and keeps its fingers crossed that keeping interest rates for banks unchanged for now will buy time for other economic forces to work.
By Dr. Kalinda Rose Stevenson
Discover how Federal Reserve interest rates determine how much money banks have available to fund your business and real estate projects in No Money Limits For Real Estate Investors. Visit NoMoneyLimits.com for your Free ”52 Heart of Money Insights.”
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