FED and Fiscal Cliff

This article is about the increased pressure upon the Federal Reserve Bank to address the fiscal cliff and the current state of the economy through open market operations. The Federal Reserve Bank is a government operated central bank that strives to maintain economic stability by controlling short-term interest rates. Open market operations are the Federal Reserve’s most important tools for exhibiting monetary policy by effecting banks reserves. The Federal Reserve, FED, is thus obligated to enact some form of monetary policy in order to combat this increasing economic uncertainty, especially as we get closer to the end of the fiscal year. Several months ago, the FED started the process of buying bonds vigorously and in December they will need to decide whether to continue doing so into 2013. They have been purchasing long-term securities and treasury bonds from banks in an effort to increase the money supply since 2008. In doing so, the banks are acquiring more money that they can then turn around and lend to businesses and individuals which reduces the interest rate. As a result of lower interest rates, investment and capital purchases are increased also promoting economic growth. This results in a stimulation of spending and consequently more production. In turn increasing the demand for labor. The demand for labor can then increase wages and reduces unemployment. However, this could possibly lead to stagflation as it did in the 1990s where there is high unemployment and high inflation. Increasing money supply will directly increase the price level because the quantity of money available is greater which means that goods and services thus overtime will become relatively more expensive. Inflation resulting from an increase in money supply however takes a long time to occur. In addition, the FED would need to create new bank reserves by effectively printing money in order to continue buying long-term bonds. This is especially troubling because it risks inducing inflation further by increasing the money supply two-fold. Mr. Bernanke in this article expresses that if we are to go over the fiscal cliff that it will be extremely detrimental and that there will be little the FED can do to mitigate it. The pressure and importance that he places upon not going over the fiscal cliff, though obviously important for him to currently do in order to try and stop it, will consequently only make the situation that much worse in 2013 if were are to go over the fiscal cliff. Mr. Bernanke, as well as many other individuals, but especially as a FED chairman, has a lot of power in what he says and this urgency only demonstrates the seriousness of how bad it will be if we do go over the fiscal cliff. Erskine Bowles today publically announced too much alarm and regret that he thought there was a two-third chance we do in fact go over the fiscal cliff. Undoubtedly, his prediction is a result of the conversations that have been taking place recently, following the election of course, between the President, CEOs, republicans, and democrats.

References:

http://online.wsj.com/article/SB10001424127887323751104578147443715538694.html