As we head into what could be the worst global recession in almost a century it is interesting to understand how one of the global financial superpowers helps to stem the tide.
Role Of The Fed
The Central Bank of America, the Federal Reserve, uses a dual mandate as damage limitation to an economic downturn by minimising unemployment and stabilising prices.
The knock-on effect of a recession will be an increase in unemployment, it will also cause prices to decrease, which in turn causes deflation.
Deflation is a less obvious aspect of economic instability but it causes a reduction in the price of goods and services.
This causes a loss in income for many people as well as the equity secured on their home.
The decrease in the value of people’s property, in line with the loan they used to buy it, can see an increase in defaulted payments which also hurts the banks as well.
Deflation can also make recessions worse by causing people to spend less, which causes businesses to decrease prices and in turn staff wages. This vicious cycle of reduction in prices due to lack of demand is known as a deflationary spiral.
Here are 3 ways the Fed helps to alleviate the damage done by a recession.
Reducing Interest Rates
By lowering their fund rates the Fed reduces the interest rates the banks use to borrow from each other.
This makes it easier for companies to borrow money to keep their business afloat, potentially holding on to their employees and keeping the economy ticking over.
It also allows consumers to get credit to buy products and services which creates demand and keeps the economy moving.
If it’s not a viable option to lower interest rates any further then quantitative easing is another way the Fed can stem an economic downturn. They are able to create new money to purchase securities.
This increase in the supply of money causes the value of the dollar to decrease which causes the price of goods to rise.
The securities purchased by the Central Bank also means that the high street banks can lend money with less risk involved, which in turn decreases interest rates as well.
The governing bodies can also regulate the banks to make sure they have enough capital available to handle a financial downturn.
By having more capital at their disposal, it reduces the risk of problems arising if customers aren’t able to make payments on any loans.
In summary, it is a bit of a fine balancing act of trying to keep prices stable, allowing the economy to grow and create jobs for the population.