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Thursday, June 09, 2011

Can the Fed Aid Economic Growth?

Does the Federal Reserve matter right now? That requires a two-part answer.

In terms of aiding economic growth, monetary policy simply is the wrong policy tool. Since the Fed slammed on the accelerator in September 2008, the economy has labored through a very deep recession and a poor recovery. So, in terms of being used as a tool to spur growth, no, the Fed does not matter.

Where the Fed does matter is when it comes to the primary responsibility - and many, including myself, arguing that it should be the lone responsibility - of any monetary authority, that is, maintaining price stability. Unfortunately, the Fed's loose money - namely, its vast expansion of the monetary base - over the past 33 months has led to stepped up inflation, and continued risk of even faster inflation looking ahead.

Predictably, the Fed's loose money, which is without precedent in U.S. history, failed to boost the economy, while it did stoke inflation risks.

Given some recent indicators pointing to further softening in an already soft economy, some are beginning to argue that the Fed should embark on a QE3 - quantitative easing three - when QE2 finishes up at the end of this month. Others argue that the Fed should take a pause to see how things develop.

Few are arguing for the Fed to tighten, in order to actually fight the inflation that the Fed is creating.

What's the concern about Fed tightening? Interest rates. Some consider even a small rise in interest rates to be economic suicide.

Two problems exist with this argument.

First, interest rates - namely, the federal funds rate, which is a primary Fed policy tool - are at incredibly low levels. In fact, since November 2008, the federal funds rate has persisted at its lowest levels, according to Federal Reserve data, going back nearly six decades. It's hard to see how a slight rise in the fed funds rate could seriously derail the economy.

Second, as inflation expectations rise and inflation takes hold, interest rates will rise due to an inflation premium. Get inflation under control, and that in turn, eliminates or reduces that inflation risk in rates.

In the end, the best thing that the Federal Reserve can do to aid economic growth is to concentrate on keeping inflation under control. After all, low inflation means low, stable interest rates, a stronger currency, and reduced uncertainty for investors and business.


Raymond J. Keating is chief economist for the Small Business & Entrepreneurship Council.

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