Guest column: The Fed plays a delicate and vital role
As a student of history, I’ve always enjoyed studying about the ancient explorers of old who set out upon oceans they did not understand. I often like to compare these voyages to the complicated economic systems we see today. Sometimes, the wind blew much too hard and pushed the voyage off course. At other times, the wind blew at just the right speed, providing a strong sense of direction. Sometimes, there was no wind whatsoever and all appeared stagnant. Worst of all were the storms that tossed things about without regard for those who might be affected.
Unlike these ancient explorers, who were largely at the mercy of mother nature, the winds of an economic system can be lightly and cautiously directed utilizing monetary policy.
Monetary policy is the process of adjusting the money supply in order to influence interest rates. When the money supply grows, interest rates fall and economic activity increases as it becomes cheaper to borrow money.
On the other hand, when the money supply falls, interest rates rise and economic activity decreases as it become more expensive to borrow money. The Federal Reserve is tasked with the job of adjusting the money supply in order to meet two fundamental goals:
1. To insure long-run price stability (also known as inflation)
2. To achieve full employment (implies an unemployment rate of around 4.7%)
These two goals counter one another. To achieve full employment, interest rates must fall in order to encourage economic growth. But economic growth eventually brings with it increasing amounts of inflation. Thus, these rules must be carefully balanced.
Gross Domestic Product (or GDP) is the total finished output within an economy. There are two ways to look at GDP – actual or potential. Potential GDP is the long-run average GDP growth over time. For the United States, this tends to trend nearly linearly upward.
On the other hand, actual GDP will fluctuate above and below potential – notice the large movement below potential following the Financial Crisis of 2008. When GDP moves strongly above potential the economy is expanding and when GDP moves strongly below potential the economy is contracting.
The Fed plays a delicate and vitally important role in balancing the two policy rules in order to lessen the fluctuations of actual GDP around that of potential GDP. This means taking action that keeps inflation on average constant through time while simultaneously providing incentives for economic growth or contraction. These goals are met by altering the money supply that in turn influences interest rates.
Without the Federal Reserve, there would be two significant consequences. First, fluctuations around potential GDP would be much larger and would happen much more frequently. The economy would eventually expand too quickly and would thus precipitate rapid economic diminution, then the cycle would happen all over again. Second, inflation would fluctuate quite a bit more.
Without any long-term “anchor” for price stability, firms and consumers would bid up (or bid down) prices and yet there would stand no central governing body to act bringing the market back into equilibrium. This would feed back into the first problem.
The Financial Crisis has prompted much in the way of discussion regarding the Federal Reserve. The institution provided huge amounts of liquidity (or dollars) to a financial system that was ailing. I’m hard pressed to imagine a world where the Fed had not stepped in to provide emergency lending services to the nation’s biggest banks.
The reality would have been starkly negative as consumers and firms would have been unable to borrow money (due to excessively high market interest rates) or access cash deposits. While there is much to be debated regarding the Financial Crisis, I believe the Fed played a central role in preventing a much worse reality.
The Federal Reserve is not without its flaws. The institution has most certainly made bad decisions in the past – think the high inflation in the early 1980s largely precipitated by interest rates held too low for too long. But without such a monetary policy authority it is highly likely that our free market system would experience regularly large and volatile fluctuations in actual GDP.
In addition, inflation would be a lot more unpredictable. Over the past 25 years, the Fed has managed to do a good job balancing the expectations of firms and consumers while simultaneously providing a solid baseline of economic stability.
May we not be so quick to criticize the institution given a seemingly impossible job.
Guest columnist Reid I’Anson has a master’s in applied economics and bachelor’s in finance. To submit a guest column, contact [email protected].