Federal Reserve

Introduction

The Federal Reserve is influenced to move the key interest rate up or down, depending upon the economy and the inflation rate. If the economy is slow, like in a recession, or the inflation goes up, then the Fed will consider raising the interest rate. If the economy is in a boom and inflation is held at bay, then the Fed will either keep the interest rate at the current level or lower it. The Federal Reserve uses the economy and inflation as gauges to calculate the key interest rate. This control over the interest rate, in turn, assists the Federal Reserve to better manage the economy and inflation. The interest rate may help to keep the economy from it spiraling out of control in either direction. Moving the interest rate up and down may also encourage consumers to spend more, jump-starting the economy. While some find it difficult understand the motives behind the Fed's interest rate adjustments, know that there is a method to the madness. The movement of the interest rate keeps the economy and inflation in balance, which makes living and spending within the United States a more manageable experience.

Why does the Federal Reserve raise and lower interest rate, and how does this affect the economy?

There is much debate over whether the Federal Reserve should tighten or further ease monetary policy. This dichotomous framing overlooks another possibility, which is whether the Fed should change the mix of its stance, tightening in some areas and further easing in others. In particular, there are strong grounds for the Fed to abandon its support of the Treasury bond market and to raise gradually the federal funds rate (to say one per cent), while simultaneously increasing its purchases of mortgage backed securities. If permissible, the Fed should also purchase state government bonds according to a per capita formula. Such a recalibration of policy could have positive effects. Increased purchases of MBS will help the housing market, which remains at the heart of the US economy's problems. Declining house prices continue to inflict financial losses on banks and consumers, and the prospect of further price declines deters buyers and undermines new construction. Increased MBS purchases could help stem this problem by further lowering mortgage rates. That would help households by facilitating more mortgage refinancing, help banks by reducing foreclosures and help the construction industry by making home ownership cheaper.

This measure would be most effective if paired with the relaxation of Federal Housing Administration, Fannie Mae and Freddie Mac standards for refinancing of mortgages. Refinancing still viable mortgages that have low or even negative equity would provide a big boost to the distressed corner of the household sector. Purchases of state government bonds would lower financing costs for states at a time of large state budget deficits. That could help avoid cutbacks to state and local government employment. Such purchases stand to help the corporate sector since MBS and state bonds are relatively close portfolio substitutes with corporate bonds. Lower MBS and ...