The article I have selected is titled; Plugging Holes and is taken from The Economist print edition of March 13, 2008. This article is related to chapter nineteen i.e. Understanding Money, Banking and Credit of our book. It is specifically related to the content about Federal Reserve System covered in the text.
The article discusses “the turmoil in the credit markets” (Plugging Holes). It highlights the defensive mechanisms put in place by the Federal Reserve Bank (Fed) to tackle this turmoil. The Fed is providing a liquidity cushion to the credit market by a “new scheme under which the central bank would provide up to $200 billion of Treasury bond to market-makers in return for dodgier assets, such as mortgage-backed securities” (Plugging Holes). Doing so it is directly serving the purpose of its mission; “to maintain an economically healthy and financially sound business environment in which banks can operate” (Pride, Hughes & Kapoor, 632).
Pride, Hughes & Kapoor cite in the text book that monitoring the nation’s money supply(through its monetary policy) to provide impetus for economic growth, is the most important function of the Fed. The article sheds lights on desperate defensive measures undertaken by the Fed to address the volatility in the bonds and credit market. The investors in the credit market have become jittery and are unwilling to invest in riskier bonds and the demand for safer government securities has increased. The wider spreads and increased volatility has led banks to charge more to borrowers. This activates a loop of effects that dents the economy. As volatility increases, collaterals charged to borrowers increase, it puts upward pressure on interest rates in turn effecting borrowings and on the whole tainting economic progress. Therefore, the Fed is exercising control over credit market to safeguard economic interests and ease off volatility in the credit market.
The Fed engages in Open Market Operations(OMOs) to control the money supply in the economy. By selling securities, money supply is contracted putting an upward pressure on interest rates, investment and consumption in economy is lowered and this slows down economic growth and vice versa. Banks and financial institutions are the main customers of government securities, therefore, lending and investment in economy is very responsive to OMOs. (Pride, Hughes & Kapoor, 634). Conducting OMOs is mainly to influence “the interest rate paid by a bank to borrow funds from another bank [i.e. federal funds rate]” (Pride, Hughes & Kapoor, 635). In the context of the article bringing about control measures in credit market serves two purposes of the Fed. It alleviates the harm caused by dysfunctional credit markets and reduces the pressure off lower interest rates, that the Fed has been using recently to fuel the slacking economy.
The article states “before this week’s liquidity actions, financial markets expected another three-quarter point cut at the Fed’s next rate-setting meeting on March 18th”(Plugging Holes). Reviewing the latest Federal Open Market Committee(FOMC) press release confirms this expectation “the Board of Governors unanimously approved a 75-basis-point decrease in the discount rate to 2-1/2 percent and lower its target for the federal funds rate 75 basis points to 2-1/4 percent” (FOMC Press Release). This comes in the midst of inflationary pressures that are devaluing dollar and increasing commodity prices. Inflation is resulting from the increase in money supply generated through lowering of discount rate i.e. “the interest rate Fed charges for loans to member banks” (Pride, Hughes & Kapoor, 635). As lower discount rates increase money supply, decrease real interest rates and increase investment and consumption in the economy.
These measures taken by the Fed are only short term and cannot be expected to ward off the inevitable tightening of credit to counter inflation. The article states that unofficial economic data suggests a recession in the economy. This recession will decrease employment levels, and increase default risk in consumer loans. Therefore, taking up riskier mortgage backed securities may hurt the government reserves. Moreover, the recent steps taken by Fed will not suffice to avoid recession. This situation will put more pressure on the value of dollar, and international countries may start switching their reserves from dollar to other currencies to avoid reserve losses. This selling will result in further depletion of dollar’s value and cause increase in commodity prices in the US.
Works Cited
“Plugging Holes”. 2008. Web.
Press Release. 2008. FOMC Statement. Web.
Pride, Hughes, and Kapoor. Business. Boston: Houghton Mifflin Company, 2008.