Fed’s Rate Cut Policy

The Federal Reserve System has for long been the major tool of monetary policy over the last hundred of years. However, with S. Bernanke becoming a new Fed’s chairman, the major policies of the Fed risk becoming rather debatable. What should we expect in future, and how important it is to have a well designed monetary policy?

The cutting of the interest rates in the United States has for long served one of the most attractive headlines in the world news. It is doubtless, that not only the U.S. economic system, but the whole world economy depends on the way the Fed regulates interest rates. These economic indices traditionally serve the major tools of regulating the speed of inflation, deflation, stagnation, and economic growth. Objectively, many of us possess sufficient knowledge as for how taxes regulate our economy, but we hardly even think of other indirect means, included into the set of monetary policies. This is why we will re-consider the basic features of Fed’s policies in the 20th century.

Historical background

“U.S. monetary policy affects all kinds of economic and financial decisions people make in this country – whether to get a loan to buy a new house or car or to start up a company, whether to expand a business by investing in a new plant or equipment, and whether to put savings in a bank, in bonds, or in the stock market, for example. Furthermore, because the U.S. is the largest economy in the world, its monetary policy also has significant economic and financial effects on other countries.” (Broz, 1997)

The Fed has served the central bank in the United States since 1913. Its central aim was to regulate the money flows, and to credit the American economy. Historically, the Fed consists of seven members. The two of them are represented by the Fed’s chairman and the vice chairman. Alan Greenspan has served the Fed’s chairman for 18 years, having retired to give his place to a new financial manager – S. Bernanke (Strongin & Tarhan, 2007).

The influence exercised by the Fed’s in its striving to support the stability of the economy allows it to exercise various legal tools in order to fulfill its tasks and to reach its economic goals. The Fed is obliged to change (or better, influence) the amount of reserve funds the U.S. banks must have on a compulsory basis. However, it would be simpler to assume that the basic obligation of the Fed since the beginning of its activity in 1913 has been creating money. As a result, the three basic monetary tools used by the Fed in its monetary policy are also directed at creating money (Broz, 1997).

First of all, the Fed can exercise its ability to purchase state securities. This is the means of supplying the banks with liquid assets and the effective tool of increasing the amount of reserves the banks possess. Second, and probably, the most important monetary policy tool of all three is the Fed’s interest rates’ regulation. What we currently observe is the gradual cutting of the interest rates, directed at stabilizing the economy and its financial flows. The third tool the Fed exercised to support the U.S. economy is “regulating the proportion of liquid reserves that banks must keep on hand. Obviously, the higher the reserve requirement, the fewer funds are available to make new loans.” (Ireland, 2000)

Monetary policy of the Fed is centered on promoting the sustainable output and stable prices in the American economy. Moreover, these two goals were fixed in the written form in the Federal Reserve Act of 1977 (Broz, 1997). It may seem difficult to understand, how the Fed can sustain the economic growth of the country through the discussed monetary policy tools. The evidence supports the public opinion in the fact that monetary policy is an efficient means of making the economy stable. According to the recent surveys, 75% of the American population are aware of the monetary policy changes initiated by the Fed, and support the interest rate cut. It is even more interesting, that only 17% of the respondents were professional economists (Strongin & Tarhan, 2007). Thus, the Fed indirectly serves the basis for the American population and business being confident in the future stability of the U.S. economy.

The Fed’s policy in the recent 20 years

Immediately after the creation of the Fed in 1913, changing the interest rates was the most popular means of stabilizing the American economy, and the most effective method of regulating financial flows within the U.S. financial system. This was mainly the instrument for expanding the amounts of available credit in regions (Ireland, 2000). “Because each regional bank set its own separate discount rate, there often was no single prevailing Federal Reserve interest rate. As financial markets became more integrated, borrowers took advantage of the uneven discount rates by borrowing from region offering the lowest rate.” (Ireland, 2000) Certainly, in this situation the monetary policy of the Fed was highly debatable and did not bring the anticipated results. According to the scientific data, the 74% of the credits during the period between 1950 and 1963 was issued by the two regional reserve banks which represented the highest level of financial misbalance in the American economy (Broz, 1997).

There is the consistent debate on whether the interest rate cut policy is correct: on the one hand, when the Fed strives for stimulating the increase of credit amounts in the economy, the short-term interest rate should be higher that the standard interest rate. On the other hand, when the failing banks are involved in these processes, there is a certain risk that the banks and the interest rate operations of the Fed will become stigmatized. As a result, healthy banks would not seek interest rated credits not to make their clients misinterpret this step. As long as the banks’ reputation is the guarantee of their successful growth, the interest rate policies could potentially produce “the overall credit growth objective of Fed monetary policy.” (Strongin & Tarhan, 2007) As a result, some economic professionals sought to resolve this dilemma by advising the Fed to provide interest rate lending only to the banks in case of emergency. Despite these assumptions, long-term interest rates remain the best economic indices, which are understandable even to the common reader. They are directly connected with the expectations people have about economy in the nearest future. Logically, each component of the American economy duly reacts to the economic expectations expressed through the level of the long-term interest rate produced by the Fed.

Another pursuing debate on the Fed’s monetary policy is connected with the constant Fed’s striving to reduce inflation to zero by regulating the level of interest rates. Is this move as positive, as one could expect it to be? Let’s consider the issue objectively. Of course, it is not necessary to have profound economic knowledge to understand that high inflation kills our economy. Traditionally we are used to the thought that reducing inflation to zero is a perfect state of economy, which we will probably never achieve. However, this assumption is false, and the monetary policy exercised by the Fed should balance between the reasonable limits of the inflation and deflation rates.

The negative consequences of the inflation growth are in hindering stable and successful growth of economy. First of all, it is more difficult to monitor the changes in the particular prices; second, it is difficult to distinguish the price growth due to inflation from that caused by demand growth.  Moreover, with high levels of inflation the economy plunges into the period of uncertainty. In this case, “it adds an inflation risk premium to long-term interest rates, and it complicates further the planning and contracting by businesses and households that are so essential to capital formation.” (Broz, 1997) In case the level of inflation reaches zero, there is a risk that short-term interest rates will also become equal to zero. Thus, the Fed will not have sufficient incentives to make these rates even lower when economy needs stimulation. Deflation is another edge of this iceberg, and it not positive as someone may think. The years of great depression have become the brightest example of what consequences long-term deflation may bring. People have witnessed the decrease in business operations and household consumption as soon as borrowing became difficult due to extremely high levels of deflation at that time (Broz, 1997).

The major difficulties the Fed’s policy faces relate to determining the real state of economy, and making proper calculations, and as a result, predictions of the future economic stability of the U.S. Scientists support the evidence of the fact that even if the key variables are up to date and are doubtlessly relevant, it is impossible to reflect these conditions in their present state. The Fed’s activity can be narrowed to analyzing the past economic activity. As a result, Fed’s policymaking is frequently compared to “driving while looking only in the rearview window.” (Ireland, 2000) This is why before creating a sound policy the Fed should make an insight into the most current economic trends, and put the obtained data into certain economic model, and to try predicting the nearest trends of economic growth or decline.

One more difficulty is connected with creating economic models. Ireland (2000) states, that the level of approximation in the variables used by the Fed is no more than 96.4%. This is a significant gap between what the Fed estimates and what really takes place within the American economy. These approximations may also serve the causes of the financial “bubbles” similar to those experienced at the end of 1990s (Strongin & Tarhan, 2007). Similar problems with variables are experienced due to unexpected developments which sometimes hit the economy (e.g. 9/11 events). This is why even in the situation when the Fed supplies us with the most relevant financial data about interest rates and expected economic trends, we cannot totally rely on it. Simultaneously, we have no other choice but to follow the Fed’s requirements and recommendations, as even being approximate, this data is the most reliable of all supplied by various economic agencies.

Politics and the Fed: Democrats vs. Republicans and the new Fed’s Chairman

The growing conflict between the Democrats and the Republicans was already visible through the early period of the Fed’s activity at the beginning of the 20th century. Actually, Republicans were initially against creating the Fed as possible means of making the federal banking system centralized. The argument was profound and could cause much political tension among the two major political parties. “As time went on the Democrats and Republicans took their stand. The Republicans were against this legislation. The Democrats made the Federal Reserve Act a part of their platform” (Broz, 1997). As a result of Woodrow Wilson becoming the President of the U.S., the bill passed the Congress, and the Fed was created.

What we currently observe in the U.S. financial system is the close conjunction of finances and politics, which they interrelate and in which they appear interdependent on each other. The Republicans and the Democrats keep to traditional political opposition, but it is even more evident than earlier than the Fed’s predictions and the future economic trends will determine the political popularity of both parties. The Democrats have consistently supported the line of cutting the interest rates. They keep to the strong opinion that cutting interest rates is the best means of promoting sustainable economic growth in the U.S. Democrats support their arguments with evidence which can hardly be debated: during 2001, the Fed cut interest rates 10 times:

“On January 10, 2001 from 6%-5.5%, on February 7, 2001 from 5.5% – 5%, on March 28, 2001 from 5% – 4.5%, on April 25, 2001 from 4.50% – 4%, on June 6, from 4% – 3.5%, on July 4, 2001 from 3.5% to 3.25%, on August 29, 2001 from 3.25% – 3%, on September 26, 2001 from 3% to 2.5%, on October 10, 2001 from 2.5% to 2% and on November 14 from 2% to 1.5%. In total, the Fed cut rates 450 basis points during the recession. The economy grew 2.7% in the quarter following the November rate cut.” (Strongin & Tarhan, 2007)

However, with the new Fed’s Chairman, and even in the light of the evident support of interest rate cut policy, the economic future of the American economy is more uncertain than ever before. Cutting interest rates was not caused by the Fed’s attempt to make economy grow, though its decline in the near future is no more denied. The fact is that cutting the interest rates was caused by the financial collapse on the housing markets. As opposed to Republicans, Democrats can gain considerable political support in this situation; the impact of both parties onto the Fed’s policy at the edge of the Presidential elections is not pushed by any economic considerations. These economic considerations are combined with the results they may bring to the political position of each of the parties; this is why it is irrelevant to evaluate the meaning of Republican and Democratic impact on the Fed’s monetary policy. The only strength of cutting rates’ policy is in possibly decreasing the rates of economic decline in the nearest future; however it is impossible to state that future interest rates’ cut will produce a miraculous effect on the growth rates in the American economy.

Under the new Fed’s Chairman, “with the latest jobs data, there’s no doubt that the Fed will act to cut rates – perhaps by a quarter of a percentage point or a half. But deciding upon future rate cuts will depend on sensitively interpreting often confusing and contradictory stream of statistics and anecdotal reports Mr. Bernanke receives every day.” (Strongin & Tarhan, 2007) The future of the Fed’s monetary policy will lie within the boundaries of the political situation and the major economic determinants. Until the Fed obtains relevant data, it won’t be able to produce more exact predictions that mere recognizing the inevitability of the economic decline.

Conclusion

The Fed’s economic policy was changing through the whole period of its existence and successful activity. The major problems which the Fed had to face in exercising its powers, was finding the rational balance between the interest rates, the level of inflation, and the economic growth rates in the U.S. Another problem the Fed currently faces is finding itself in completely uncertain situation due to political opposition of Democrats and Republicans. It is evident that the current Fed’s Chairman will continue the policy of cutting interest rates, as supported by Democrats. However, in the light of the economic data being no more than approximate, it is difficult to produce any reliable predictions as for the future of the American financial system. What is evident is that the Fed currently finds itself in the position more uncertain than ever in its history.

 

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