By
Kalinda Rose Stevenson, PhD
Can the Federal Reserve stop a recession or prevent inflation by its actions? On Tuesday, August 5, the Federal Reserve voted to keep the interest rate for banks unchanged at 2 percent. 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 streetlight. Bob sees Joe looking at the sidewalk under the streetlight 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 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 streetlight, 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?
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.
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?
The decision on August 5, 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? Will it either prevent recession or inflation? Wall Street responded favorably to the Fed's decision to keep interest rates unchanged, but it is important to note that Wall Street was already responding favorably because oil prices have fallen.
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 streetlight, and keeps its fingers crossed, hoping that keeping interest rates for banks unchanged for now will buy time for other economic forces to work.
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