Prior to the current economic downturn the Fed could shift the direction of the economy by making relatively modest purchases or sales of US Treasuries. They sold treasuries to shrink the money supply and increase interest rates when they worried about inflation and they purchased treasuries and lowered interest rates when unemployment was a concern. The Fed has played a much greater role in the economy since the banking crisis. It participated in the bailout of the banking system by purchasing assets other than treasury bills from banks and other financial institutions and it made loans to other institutions that needed cash. Its balance sheet is much larger and much more diversified than it has been in recent history.
Most recently, it has decided to purchase up to $600 billion of long-term debt from the Treasury. They hope that this will halt the decline of the price level in the economy and prevent a potential deflationary spiral like that which occurred in the Great Depression and, more recently, in Japan. It should also keep interest rates low and encourage spending that might enable the economy to recover more rapidly from its downturn. This decision is not without its critics. I have provided an overview of the issues raised by this unusual development.
The Fed has traditionally played a much different role in the economy. By prudently managing the money supply and interest rates it has done a good job of preventing price inflation and in maintaining price stability and reasonable levels of economic growth. The purchase of $600 billion of long-term treasuries will greatly expand the money supply and many worry that it will lead to price inflation. By increasing the money supply it may also cause a decline in the value of the dollar. A cheaper dollar might make US products more attractive to our trading partners and increase exports. This message has not been lost on our trading partners who fear that it might limit their exports to the US. It might also cause the prices of commodities purchased with dollars to rise and contribute to inflation. For example, oil prices are based on the dollar and a fall in the value of the dollar will cause the price of imported oil to rise. Economic growth in emerging markets, such as China and other fast growing markets, has also increased the demand for many commodities such as cotton and copper and their prices have increased substantially.
On balance, the Fed made a tough decision, with considerable risks, because it believed that the consequences of inaction were worse than those of the action that it is taking. Not surprisingly, the reactions to the Fed decision have been strong and varied. Some believe that they are doing too little to late and that the contribution to recovery will be weak. Others, have reasonable concerns about the potential for price inflation and about the potential decline in the value of the dollar. Unfortunately, there have also been unreasonable concerns raised by those who have little understanding of the economy or monetary policy in particular. Sarah Palin, gave a recent speech, intended primarily I assume for her constituents, that demonstrated her lack of understanding but also her ability to create fear and misinformation about vital issues. Our problems are many, and the answers are not easy, but they are made much more difficult when media celebrities and politicians, who worry primarily about the next election, intentionally mislead the public.