Monetary Policy Article

Tim Shaughnessy: Effectiveness of Fed's monetary policy debatable
August 25, 2007

News reports about the Federal Reserve generally do not make the front page but if you sifted past the headlines you saw that the Fed cut the "discount rate." Since people refer to the chair of the Fed as the second most powerful person in the world, it might be helpful to unpack some of the details of the Fed's latest move to see how it affects the economy.

The primary purpose of the Fed is to maintain a sound monetary system leading to low inflation and unemployment, while ensuring smooth and trustworthy operation of banks and financial transactions. In short, the Fed's role is to control the money supply. If it injects more money into the economy, this tends to temporarily spur production of goods and services; in the long run, though, too much money will lead to inflation. If the economy heats up and inflation is looming, the Fed will pull money out of circulation, leading to lower prices but less production.

In the Fed's role as a "bankers' bank," it can change the money supply using the discount rate. In a similar way that I have an account at AmSouth, AmSouth has an account at the Fed. I can borrow money from AmSouth; AmSouth can borrow from the Fed. AmSouth charges me an interest rate when I borrow; the Fed charges AmSouth to borrow, and it calls this rate the discount rate.

The official announcement said the rate was cut "50 basis points," which is just a fancy way of saying half a percent. (Like all economists, the Fed sounds smart when it renames already familiar terms.) Thus, it is now half a percent cheaper for banks to borrow money from the Fed. They borrow more and turn around and lend it out so the money supply increases, which hopefully causes more production of goods and services.

Why did the Fed do this now? "To promote the restoration of orderly conditions in financial markets," according to its press release. The sub-prime mortgage market woes threaten to put the brakes on the economy, so the Fed cut the discount rate as an antidote. The stock market seemed to appreciate the move as the Dow, Nasdaq, and S&P 500 all moved up about 2 percent, reflecting investors' optimism that the easier lending by banks will help the economy.

There is much debate within economics about the effect and effectiveness of monetary policy, with some believing that the Fed is good at fighting inflation but not so good at preventing recessions, and some who think the Fed cannot affect output at all in the long run. We will have to wait and see whether the discount rate cut was the right medicine.