Why Sleepy Hollow Is an Incubator for Change

¶ … Federal Reserve uses to influence a healthy economy. The first section discusses monetary policy, and is followed by a second section that focuses on fiscal policy. A limited conclusions section is provided.

Monetary Policy Recommendations

The Fed employs three primary tools to influence monetary policy: reserve requirements, open-market operations, and the discount rate. The simplest way to explain monetary policy is consider the tools used to reduce the cost of credit, a fiscal change that enables more individuals and companies to borrow money. In economic argot, this results in the economy heating up. Interest rates, which are essentially the cost of credit, are impacted by the amount of money available and the performance of the economy.

Depository institutions must hold a certain amount of deposited physical funds as vault cash or in accounts with the Federal Reserve Bank. The amount of money that banks can invest or loan is determined by reserve requirements set by the Board of Governors -- usually around 10%.

Banks pay an interest rate on the short-term loans they obtain from a Federal Reserve Bank; this is the discount rate. The discount rate signals changes in the Fed's monetary policy to the market. Currently, credit-worthy borrowers find loans very cheap -- interest rates are so low, and there has been a slight easing of credit standards.

The real target of the short-term interest rate manipulation is inflation: the Fed's goal is 2% inflation in the long-term. The index most commonly used by the Fed to gauge inflation is the core personal consumption expenditure price index or PCE. The chart below illustrates the Fed's performance with respect to the 2% inflation target over the past decade and a half.

Historical Fed action is interesting, but not instructive for the present economic climate. To wit: In 1990, short-term interest rates were driven from 9% down to 3%, and in 2001, the rates were driven from 6.5% to 1%. The 2008-2009 recession saw rates drop from 5.25% to zero. But this "zero lower bound" just caused investors to hoard cash and not lend -- the recession deepen and monetary policy could not gain traction. When the private sector won't spend and monetary policy is ineffective, the government must step up to the plate. Although economists assume positions in different camps -- and tend to exhibit an exaggerated loyalty to their theories, a Keynesian approach is a solid framework for addressing depressions and recessions. Moreover, behavioral economics makes it plain that the realities of the finance markets need to be integrated into macroeconomics. The Fed's quarterly easing remains a viable tool for positive impact, but the time lags in monetary policy are unpredictable, other than they are long. The Fed should continue the current interest rate for several quarters -- all things remaining equal.