Federal Reserve Policy in the USA - Term Paper Example

Federal Reserve Policy The US economy has cooled down to the slowest growth rate in decades and unemployment has reached levels not seen in years. On a global basis, major banks have failed here and abroad as the illiquidity in the system has brought credit availability to a halt. The lack of credit, the lifeline of business, has threatened the ability of firms to do business and expansion is left as an impossibility. Consumer loans for automobiles, appliances, and other goods are difficult to obtain, and when it is available it is expensive. The weakness in the real estate markets has spread to become a system wide problem as sub-prime loans turn into toxic assets leaving financial institutions under-collateralized. The US Federal Reserve Board has been criticized for enacting policies that exacerbated the problem, or at least for failing to curtail the spread of the problem by its lack of action. The purpose of this paper is to examine the policies of the Federal Reserve Board during the period of 2006-2009 in light of the current financial crisis. The paper will find that the Federal Reserve Board policies during this period were prudent and appropriate, but failed to exert the political will necessary to address the problems that have arisen in the financial system that were due to factors that are beyond the Board's authority. By many accounts, the current financial crisis began in the housing industry and was fuelled by the twin problems on over-evaluation and high-risk mortgage loans. As the problem grew, financial institutions continued to make high interest, high-risk loans on property that had reached values that were unrealistically high. When the real estate bubble burst, many of these institutions and borrowers were left with assets worth far less than the amount due on the loan. According Bernanke (2008), "housing and housing finance played a central role in precipitating the current crisis. As the crisis has persisted, however, the relationships between housing and other parts of the economy have become more complex.Declining house prices, delinquencies and foreclosures, and strains in mortgage markets are now symptoms as well as causes of our general financial and economic difficulties". Yet, could the Federal Reserve Board (FRB) have taken steps beginning several years ago to address theses causes of system wide failure Bernanke (2008) is very clear that the problem was "declining house prices, delinquencies and foreclosures, and strains in mortgage markets". In fact, the FRB was aware of these problems, but failed to enact policies to address these complex issues. Bernanke lists the first cause of the current crisis as the falling prices of housing as the real estate bubble burst. In a free market, asset prices will work to reach equilibrium. A bubble in any industry will eventually deflate in an effort to reach its true valuation. This was seen in the collapse of technology stocks in 1999-2000, and now has hit the real estate market. However, the FRB may have not been able to deal with this problem effectively. In retrospect, Stern (2008) states, "it is challenging at best to identify when asset prices have reached excessive levels, to build support for action once identification has occurred and to implement corrective policy successfully". There is a general philosophy in the FRB that the best strategy for asset inflation is a policy of containment and clean-up, rather than prevention (Stern 2008). In fact, the FRB's policy was "monetary policy easing and last-resort lending", which only deepened and prolonged the crisis (Blanchard 2009, p.2). Asset revaluation is a political challenge, but is within the FRB's capacity. None of these actions took place, and the FRB continued dropping interest rates. While the falling interest rates were enacted to stimulate a lagging economy, other factors continued to prop up housing prices at unrealistic levels. When mortgage money is cheap, it creates more customers interested in borrowing and the demand for housing remains high. During the period of 2006-2009, the FRB continued to increase the money supply, stimulated demand through low interest rates, and stretched consumer credit to record levels. This was additionally aided by an increased gap in our balance of payments brought on by the high levels of Chinese imports. Some of this could have been eased through a restructuring of China's exchange rate, which has remained at an unrealistic level. Though the FRB has no direct authority in this area, they exert significant political influence on these policies. This move also tended to increase inflationary fears, which went unheeded as inflation began to rise. According to Fiedman (2000, p.45), "When the central bank buys securities, it makes payment by increasing the reserve account of the seller's bank, thereby increasing the total volume of reserves that the banking system collectively holds. When the central bank sells securities, it receives payment by reducing the reserve account of the buyer's bank, thereby reducing the total volume of reserves". This high demand translated to higher prices, and inflated the real estate bubble, rather than relieving the pressure. Jordan (2006, p.502) argues that "the excess supply of such monies will cause purchasing power to erode as the weighted average of money prices that are rising will exceed the weighted average of prices that are falling". The end result of these actions is inflation. According to Reynolds (2008), "The producer price index rose 1.2% in July [2008] alone, about double the increase expected by economists. [...] Excluding food and fuel, the index surged 0.7%, also more than expected. The overall index last month was up 9.8% from a year earlier, the sharpest rise since 1980-81". Clearly, the FRB has failed to maintain any real level of stability in the economy or the financial markets, as credit dried up and inflation began to spiral. The falling real estate prices were experienced during a period of rising delinquencies and foreclosures on homes. As many as 20 percent of the existing mortgages are "under water", or have loans that exceed the value of the property (Bernanke 2009). In line with their policy of containment and clean-up, the FRB has enacted numerous policies and programs designed to address the problem of foreclosures and keep homeowners in their homes. However, they have had little impact on the overall condition of the market or the economy. According to Bernanke (2009), "the available evidence suggests that the homeowner's equity position is, along with affordability, an important determinant of default rates, for owner-occupiers as well as investors". Improving the homeowner's equity position can only be accomplished by writing down the principle and restructuring the loan. There has been little accomplished in this area. "Despite good-faith efforts by both the private and public sectors, the foreclosure rate remains too high" (Bernanke 2009). While the FRB may not be able to directly make the necessary funds available to homeowners, investors, and banks to adjust the principle on the under water loans, they have substantial influence on the policies of Washington agencies that could. By many expert accounts, the current financial crisis was precipitated by the variety of high-risk financial instruments that were entered into by investment banks, lenders, and mortgage companies. While sub-prime loans have been a central public cause, a wide range of derivatives and credit instruments that created a false demand in the housing industry accompanied them. Blanchard (2009, p.2) contends that "huge risks accumulated below the regulator's radar, in banks and in the shadow banking system". This would seem to indicate that the FRB was unaware of the fomenting problem, but that is simply minimizing their failure to act promptly. According to Chomsisengphet and Pennington-Cross (2006, p.32), "preliminary evidence indicates that the probability of default is at least six times higher for nonprime loans (loans with high interest rates) than prime loans. In addition, nonprime loans are less sensitive to interest rate changes and, as a result, subprime borrowers have a harder time taking advantage of available cheaper financing". This evidence was published in 2006, the same year that the FRB published its three-year strategic planning document for 2006-2009. They listed as one of their monetary policy goals to "stay abreast of recent developments and prospects in the U.S. economy and financial markets, and in those abroad, so that monetary policy decisions will be well informed" (Board of Governors 2005, p.5). Not only did the FRB fail to react to the growing crisis, they did not even fulfill their own basic goal of staying well informed. The fundamental strategy of the FRB has been to keep inflation in check and insure maximum employment. With the systematic failure of the financial system, unobtainable credit, banking and business failures, and spiraling inflation, high unemployment has also been a manifestation of the systemic problems. With tight credit, small and medium sized businesses have been unable to expand, or even sustain, their operations. With no new job creation, and the losses of thousands of manufacturing jobs, the unemployment rate has reached record levels. As of this writing, the national unemployment rate has hit 8.5 percent, the highest rate in the last 25 years (Tasci & Mowry 2009). However, much of this unemployment has been the result of restructuring that has been taking place for several years, and is beyond the FRB's ability to control. In fact, in 2007 the FRB took several aggressive steps to stabilize the economy. They aggressively were purchasing securities and lowering interest rates. However, it was generally criticized by economists as too little. Much of the growth in the economy in the last 7 years has come from increased productivity, and not job creation. The Bush administration placed pressure on the FRB to spur growth at the cost of jobs or a basic restructuring of the economy. The problems at General Motors are not new and have been brewing for several years. Yet, Washington and the FRB did not have the political will to address the problems at an earlier date. The supply side economic policies of the Bush administration further deepened the problem as the FRB stood by and neglected to act. The deficits, which were for the most part caused by the tax cuts, increased the national debt and did nothing to stimulate the economy. The way the tax cuts were structured, they did not put money into the economy, and did not increase the demand for consumer goods. Demand side economics would have called for tax cuts for the lower income levels as a way to increase consumer spending and stimulate manufacturing and retail, where the jobs are created. The FRB did speak out against these tax cuts, but in the tradition of the Board of Governors, dissent was quiet and never reached the level of public discourse. In conclusion, it is clear that the FRB did little during the period of 2006-2009 to ease the effects of the current economic crisis. The question is; could they have done more. Clearly, the FRB should have intervened to stem the rising tide of risky investments on over-priced real estate. This is a hard issue to form a policy on. The US has a long tradition of government restraint in the economy, and price manipulation is generally considered off limits. Yet, they can do more by working through banks and financial institutions to make these investments, for investors and homeowners alike, less attractive. Large financial institutions have operated under the Too Big To Fail philosophy, and the FRB needs to structure the system so that no institution can expect a bailout if it fails. While the twin evils of inflation and unemployment have been the focus of the FRB, they need to understand how these factors are influenced by aspects other than just interest rates and money supply. In the complex global economy, there are many inter-dependent factors, such as the balance of payments and exchange rates, which influence the long-term stability of the economy. These disruptions eventually ripple through inflation and higher unemployment. The FRB has taken the basic steps needed to stabilize the economy, but have been unwilling to flex its political muscle and enter the public discourse in a meaningful way that could influence policy decisions made outside its own agency. References Bernanke, B, 2008, ' Housing, mortgage markets, and foreclosures', Speech presented at the Federal Reserve System Conference on Housing and Mortgage Markets, December 4, 2008, Washington, D.C. Blanchard, O, 2009, 'Lessons of the global crisis for macroeconomic policy', Paper prepared for the research department, International Monetary Fund, Washington, DC. Board of Governors of the Federal Reserve Board, 2005, Strategic planning document 2006-2009, Federal Reserve Board, Washington, DC. Chomsisengphet, S, & Pennington-Cross, A, 2006, 'The evolution of the subprime mortgage market', The Federal Reserve Bank of St. Louis Review, vol.88, no.1, pp.31-56. Fiedman, BM, 2000, 'The Role of Interest Rates in Federal Reserve Policymaking', in Kopcke and Browne (eds.), The Evolution of Monetary Policy and the Role of the Federal Reserve in the Last Third of the Twentieth Century, Boston: Federal Reserve Bank of Boston, 2000. Jordan, J L, 2006, 'Money and monetary policy for the twenty-first century', The Federal Reserve Bank of St. Louis Review, vol.88, no.6, pp.485-510. Reynolds, M, 2008, 'Jump in inflation puts Federal Reserve on the spot', Los Angeles Times, 20 August 2008. Stern, G, 2008, 'Issues in macroeconomic policy', Top of the ninth: Gary Stern's remarks at the European Economics and Financial Centre, London, March 2008, viewed 22 April 2009, . Tasci, M, & Mowry, B, 'March employment situation', Federal Reserve Bank of Cleveland, Cleveland OH, viewed 21 April 2009, . Read More