The Fed needs to do It's Job

By Dr. William W. Woolsey, Special Economic Correspondent of The Free Enterprise Foundation.

The Federal Reserve needs to do its job. The revised GDP figures for the fourth quarter of 2008 show severe macroeconomic problems. Rather than shrinking 3.8%, the economy lost production at a 6.2% annual rate. The new figures provide evidence that the key problem is falling expenditures. During final quarter of last year, total spending fell at a 6.4% annual rate. Businesses in nearly every area of the economy were selling less, and so they were producing less. One important consequence was the increase in the February unemployment rate to 8.1%

In the third quarter of 2008, total spending was growing 2.5% a year. This is substantially below the 5% annual spending growth over the last decade, but only a bit lower than the 3% that would consistent with long run price stability. However, in the fourth quarter, slower spending turned into a free fall.

Responsibility for maintaining aggregate expenditure in the U.S. economy rests with the Federal Reserve. Because of its power to create (or destroy) money, there is no limit on spending. Productive capacity puts a limit on our real income and the willingness of people to work at realistic wages puts a limit on employment, but increased spending is “easy.” Even the Reserve Bank of Zimbabwe is able to generate massive spending in their economy. While following the example of Zimbabwe would be a disaster, it remains true that if there is too little spending, the Fed has created too little money.

Unfortunately, there is no simple, mechanical relationship between the creation of money by the Fed and spending in the economy. Do the banks hold the money the Fed creates or do they lend it? Do people hold the money created by the Fed and the banks or do they spend it? But because the Fed’s power to create money is so great, it can overwhelm all other factors and increase spending whatever amount is necessary.

What should the Fed do now? First, it should commit to returning spending to its previous 5% growth path— $15 trillion in second quarter 2009, $15.2 trillion in the third quarter, $15.4 trillion in the fourth quarter, and $15.6 trillion this time next year. If people understand that the Federal Reserve is committed to do whatever it takes to keep spending on target, that should help turn around expectations and return spending to target.

Second, the Fed should stop paying interest on reserve deposits. Last October, the Fed began paying banks to leave funds on deposit in reserve balances at the Fed. In effect, the Fed is paying banks not to lend. While the interest paid is very low, only 1/4th percent, the policy depresses spending. A better policy would be to charge banks for holding excess reserve balances at the Fed. The Fed has traditionally restricted bank lending by requiring them to hold reserve balances, approximately 10% of checkable deposits. Banks are currently holding $820 billion in reserve balances at the Fed, well over the $700 billion in checkable deposits people keep in banks. The reserve ratio is approximately 116% of checkable deposits!

The reason why spending in the economy has fallen is that fear and uncertainly has resulted in an increase in the demand for short-term, low-risk financial instruments. The low interest rates on Treasury bills reflects the scramble for safety. People have also accumulated funds in FDIC-insured bank deposits. And the banks are accumulating funds in balances at the Fed. Charging banks for the privilege of parking funds at the Fed should motivate banks to lend, which will expand the quantity of FDIC-insured deposits. The quantity of money needs to expand enough to meet the temporary increase in the demand to hold FDIC-insured deposits.

Third, the Fed’s target for the Federal Funds rate should be cut to zero. The current target for Federal Funds is a range between .25% and zero, but it is generally trading closer to .2%. With the rapid drop in spending, the Federal Funds rate and interest rates on the T-Bills should go to zero. This could easily result in interest rates on FDIC-insured checking and savings accounts falling to zero as well. People who want to earn a return need to take risk. AAA corporate bonds are paying 5%. There are bargains in the stock market.

Fourth, the Fed should get serious about quantitative easing. While it announced a policy of quantitative easing last fall, the Fed has largely continued its efforts to revive the loan securitization market on Wall Street. Quantitative easing needs to be focused on increasing the quantity of money to meet the demand. Once T-bill rates and the Federal funds rates are at zero, the Federal Reserve should go ahead and buy up all the T-bills. And then longer term Treasury notes and bonds. And then AAA commercial paper, and on from there. The Fed should do whatever it takes to get spending back up to its previous growth path.

The commitment to targets for spending work both ways. As confidence returns, the demand for low-risk, short-term securities like T-bills, FDIC-insured bank deposits, and reserve balances at the Federal Reserve will fall. Interest rates on these assets will need to increase and the Fed will need to sell off many of the assets it has accumulated and reduce what will then be an excessive quantity of money. Failure to make the necessary adjustments as the economy recovers would result in spending rising above target and excessive inflation.

The aftermath of the housing bubble will require a reallocation of resources, resulting in temporary reduction in production and higher unemployment. The large banks and other financial institutions that heavily lent into the bubble cannot be reorganized without at least some disruption to the real economy. But there is no need for these disruptions to be compounded by a collapse of spending. The Fed needs to do its job—maintain total spending.

Copyright © 2009 by William Woolsey and The Free Enterprise Foundation. All rights reserved

About the author: Professor William Woolsey is a member of The Free Enterprise Foundation's editorial staff and senior writer on national economy reporting. Dr. Woolsey is a distinguished Professor of Economics in the Citadel’s School of Business Administration and a former Libertarian candidate for Congress.

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