Business Insider

Peter Crabb: The Fed needs to take action to salvage its credibility

Peter R. Crabb
Peter R. Crabb

Federal Reserve policymakers are in danger of losing every ounce of credibility the financial markets have given them the past few years.

In June of this year, Federal Reserve Chairman Ben Bernanke announced that when the U.S. unemployment rate fell to 7 percent, monetary policy would change. Specifically, the Fed’s program of $85 billion of U.S. government debt and mortgage-backed securities every month would come to an end.

The day of reckoning is here. The U.S. Department of Labor announced on Dec. 6 that the unemployment rate fell from 7.3 to 7 percent in November. In the Treasure Valley, the unemployment rate is even lower at 5.7 percent, and it has fallen steadily for the last three years.

While economic growth is slow, economic conditions are clearly improving. If the Fed doesn’t make good on the earlier commitment, volatility in the financial markets will increase and inflation expectations will rise.

In 1913, the U.S. Congress established the Fed and charged its governing body, the Federal Reserve Board of Governors, with maintaining a sound and stable financial system.

Almost all commercial banks in the U.S. are members of the Federal Reserve System and are required to keep deposits, or reserves, with the Fed. This creates a large pool of funds not directly used in the economy.

Historically, when banks got into trouble, say by not having enough cash flow from their loans to pay their depositors, the Fed would use reserves to lend the troubled banks money until their cash flow improved.

However, the Fed governors and policy analysts quickly learned that the Fed could influence banking activity, and therefore economic activity, by changing the level of reserves banks held. It is now part of the Fed’s mission to encourage economic growth and keep inflation in check by changing the incentives banks have to lend out these reserves.

The theory is pretty straightforward: When the Fed increases reserve levels in the bank, it should encourage lending, which in turn may increase economic activity.

But while the theory is sound, the application is not. The unfortunate fact for monetary policymakers is that they cannot control or predict investor and banker behavior. That is, the Fed cannot perfectly control the amount of money in the economy.

Since the financial crisis, the Fed has kept interest rates at historic lows and increased bank reserves dramatically. Banks have plenty of cash to lend at low rates. This easy monetary policy has not achieved faster growth in the real economy, just higher inflation expectations and financial price volatility.

Further, by keeping a lid on interest rates, the Fed has done nothing but move money around.

As Mark Calabria reports for US News and World Report, since 2008 the interest U.S. households pay each year on their mortgages and other debts has fallen by about $400 billion.

This drop in interest expense has been offset by an equal drop in U.S. household income from interest (e.g., earnings on savings accounts). Lower interest rates are benefiting some households, but simply at the expense of others.

When Fed policymakers meet again this week, they need to end the bond-buying program and announce that interest rates will rise soon. Anything else is just going to hurt their credibility more.