Monday, November 23, 2009

The Fed Is Under Fire

Yesterday I read, "Fed Under Fire As Public Anger Mounts." The public, not understanding what the Fed does is angry over the fact that the banks are now going to be paying large bonuses to its employees, and for the bail out. But, as former Secretary Paulson said, the lack of knowledge about finance and monetary policy and theory among even the educated has lead us to this point. Why blame the Fed? I guess because they are an easy target because few really understand what a central bank does. They become the scape goat for the blunders and mistakes of the Congress.

Our Fed, our central bank, is charged with running monetary policy for the country. The Fed can not control the economy, yet it certainly can influence the supply and demand for money. The Fed has basically three tools to influence monetary policy. The first is Open Market Operations. This is where the Fed buys US Treasuries from the banks and thus puts more reserves into the system. By selling US Treasuries, the Fed can take reserves out of the banking system. This buying and selling influences the growth rate of the money supply which is something the Fed is responsible for. The Fed wants there to be enough money in the money supply to carry on the business of commerce and trade. Second the Fed can influence interest rates by raising and lowering the interest rate at which banks lend each other reserves. This is referred to as the Fed Funds rate. And, third, and the biggest tool is the reserve requirement which the Fed can change and by doing so can help create more credit or less credit in the system. Banks can create loans from deposits. When they create a new deposit, they can lend a percent of that deposit, and continue the practice until there are no more reserves to hold against the original deposit they have received. In this way, Banks can expand the money supply as people and businesses borrow to make new purchases.

The Fed, in my opinion, has two jobs. The first is to protect the integrity of the US dollar. The second job is to see to it that there is enough money, the growth of the money supply, to carry on the business of the economy.

Congress passes laws that makes the Fed's job more complicated, but they do not know this. The end of the Glass-Steagall Act in 1999, created a banking system that the Fed could not control and whose influence was at risk. Now after the Financial markets and the economy have hit bottom, the popular thing to do in Washington is to blame the Fed. The Fed did not make all the mess. The Fed may have kept interest rates too low for too long a time under former Chairman Greenspan, but the Fed did not cause the resulting economic meltdown. The Fed that runs monetary policy as our central bank makes a good scape goat because Congress does not understand monetary policy nor monetary theory. This leaves the Fed the perfect whipping boy of the people.

If the Congress and the Obama administration are serious about fixing the economy, then they should come to the aid of the Fed and not let the ignorant take the lead in bashing the Fed. We need a central bank in an economy where credit and the movement of credit is so important. It is time for Congress to learn something about the limitations of the Fed and monetary policy. The Fed can not fix everything that Congress breaks.

Stay tuned.


LceeL said...

I am going to forward a copy of this post to Senator Durbin, from Illinois.

moneythoughts said...

OK, but I sure hope they don't blame me for the financial crisis and bond market meltdown. I didn't have a thing to do with it. I am just watching the events from the sidelines like everybody else.