What Can the Fed Do to Aid our Economy? Not Much More Than it Already Has

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US Federal Reserve Board Chairman Ben Bernanke

The United States Federal Reserve's policy board announced today it will extend its period of extremely low interest rates through 2013 if not longer.

But don't expect that to solve the nation's financial woes.

A macroeconomic look at the U.S. economic slump makes it clear that the Fed is limited in what tools they have to fix the economy, and they have already used most of the tools at their disposal, without much success.

  • Lowering interest rates: The Fed typically tries to help the economy by inserting more cash into it - loose monetary policy. The classic tool in the Fed's hands is to lower interest rates which makes credit less expensive and puts more money in the economy.  The central bank has already done that, bringing the federal funds rate right down to zero. Of late, it's not very effective in stimulating economic growth.
  • Quantitative Easing: This is basically inflating the Fed's balance sheet by buying government bonds, which has the effect of putting more liquidity or money into banks. The banks could then lend even more, but the problem is, they aren't.  The banks are cautious, companies are cautious and consumers are saving more.  So QE hasn't worked as much as hoped for either.

The underlying problem of the economy is not a lack of liquidity —or cheap credit — that could (emphasis on 'could') be used in production, i.e. stimulating the economy.

"The problem is that an awful lot of people aren't credit worthy or don't want to borrow," said Professor David Beim at Columbia Business School. According to Beim, the biggest obstacles to economic growth aren't monetary but are structural and won't be solved through the Fed's policies. 

"Everyone is trying to save to try to work their debts down and that's a problem that is not solved by throwing money at people. Banks have money to lend people, but people really ought not to be borrowing because they're over indebted already," Beim said.

Another economic problem is the over abundance of residential houses and commercial buildings — we have more than we need.  While we slowly sell off those homes, waiting for the overstock to be absorbed, Beim suggested that the Federal government help people and companies whose mortgages are underwater by providing incentives to banks to refinance those mortgages.

The federal government does have tools at their disposal —programs, tax plans and other inducements to help consumers shrink their debts. Unfortunately, getting anything approved in Washington, even if it's to help the struggling American worker, appears to be next to impossible.

In the meantime, don't expect the Fed to step in to save the day. 

"The Federal Reserve can only do so much and particularly in the current situation is very constrained," Frederic Mishkin, a professor at Columbia University's Business School and a former member of the Board of Governors of the Federal Reserve.