Business Insider

Peter Crabb: Fed's action may bring higher prices, but will it spur lending?

We all face tradeoffs. The most difficult tradeoff in our economy continues to face the Fed.

The Federal Reserve was created in 1913 in response to a series of U.S. financial panics, culminating in the particularly severe panic of 1907. Well, it looks as if we have another panic on our hands today. But the Fed must nonetheless continue with its regular work in support of its stated mission: to keep employment high and inflation low. Unfortunately, these two goals are conflicting.

The Fed was created by an act of Congress to serve as a lender of last resort, a bank regulator, and a monitor of the money supply. This last job, otherwise known as monetary policy, is governed by an internal committee, the Federal Open Market Committee.

The FOMC conducts open-market operations to implement monetary policy. Open-market operations are the purchase and sale of U.S. government bonds to increase or decrease the level of bank reserves (the money supply) respectively. Open-market operations are the most commonly used policy tool to conduct monetary policy.

On Wednesday, the FOMC announced it will lower the target federal funds rate by 0.5 percentage point to 1 percent. The committee does this by purchasing more government bonds. This increases the value of the bonds and lowers the interest earned.

The purchase of more bonds also increases the amount of money banks have to lend. If there is more money in the marketplace, the value of this money goes down. The banks may have more money to lend now, but its lower value means higher inflation.

Oil and gold prices rose on the day with this news. With higher inflation, the value of commodities will rise. Long-term bond markets also indicate higher expected prices. The benchmark 10-year U.S. Treasury Note fell in value, raising its interest rate closer to 4 percent.

Wednesday’s action by the Fed suggests it is less concerned with one of its goals, inflation, and more concerned with the other, employment. The Fed has given us all a stronger incentive to borrow. Banks have a lower cost of funds, and consumers will likely see lower interest rates for car, home and many other loans.

The incentive to borrow is there, but will anyone act on it? That’s the question. If they don’t, all we’ll get from Wednesday’s announcement is higher prices.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.