The Pressure is on the Fed Now to Save the Economy

Can monetary policy fix the nation's many economic woes?

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The Federal Reserve is feeling the heat. After a month marked by poor economic indicators, political wrangling over the debt ceiling, a U.S. credit rating downgrade and a stock market rout, Ben Bernanke and the Fed are increasingly pressured to find a fix for the nation's economic problems. But the central bank is also finding itself boxed in by political gridlock and a near-empty toolbox.

[See why S&P had to downgrade the U.S.]

Today after a meeting of the Federal Open Markets Committee, the Fed announced an essentially unchanged monetary policy going forward while offering a more downbeat take on the present state of the economy. The Fed said in a statement that economic conditions warrant "exceptionally low levels" for the federal funds rate, the interest rate at which banks can borrow from each other, through mid-2013. The federal funds rate target has been between zero to 0.25 percent since December 2008. The lack of policy movement today is a reflection of the lack of options not only at the Fed's disposal, but at Washington's disposal.

The recent debt ceiling debate showcased the current Congress' unique difficulties in achieving compromise, meaning that agreement on conventional economic stimulus policies seems virtually impossible. This puts the Fed in a difficult position, says Martin Eichenbaum, a professor of economics at Northwestern University. "Most economists would like to expand government purchases in the short run but at the same time credibly commit to reforming system down the road," says Eichenbaum. "The Fed never wants to be in a position of responding to the other branches, but it's clear that their choices would be different if there was a large fiscal stimulus," which is unlikely in the current political climate.

Reducing the federal funds rate—impossible when it is being held at zero—is one of the key monetary policies most often used to stimulate the economy. The other is increasing the money supply, which could come in the form of a third round of quantitative easing, a move in which the Fed makes a large-scale purchase of assets from banks.

[Read analysis of the latest job numbers.]

The financial world was buzzing about the possibility of QE3 even before Federal Reserve Chairman Bernanke indicated at a July congressional hearing that such a policy was on the table. Though the Fed did not make any moves toward easing today, it did leave its options open. The Committee reported that it "discussed the range of policy tools available" and that it is "prepared to employ these tools as appropriate." Nonetheless, three Fed members dissented—a sign of virtual mutiny.

The fact that QE3 has gained such widespread attention and approval may itself be a sign of desperation. "If you drew up a list of 15 things that could be done in Washington to help support economic expansion and get unemployment down, quantitative easing by the Fed may be no. 14 or 15 on the list. The reason we're focusing on 14 or 15 is that everything else is tied up by political gridlock," says Vincent Reinhart, a former director of the Federal Reserve's Division of Monetary Affairs and a resident scholar at the conservative American Enterprise Institute.

Quantitative easing's very efficacy is itself questionable. David Beim, professor of finance and economics at Columbia Business School, says that the policy's unproven effectiveness and its very premise make it an unpalatable option. "What quantitative easing does is put more reserves into banks. To give them more doesn't change their position." One policy option that could encourage banks to do something other than sit on their reserves is to reduce the interest rate that the Fed pays to banks on their excess reserves. However, says Reinhart, the benefits of this policy would be small.

It appears that the government's hands are tied in terms of what it can do to boost demand and spur job growth, a fact that even lawmakers admit. In a visit to her home state on Monday, Missouri Sen. Claire McCaskill told her constituents that it is unlikely that Congress will pass a jobs bill this year, as the Southeast Missourian reports. "I think it's very doubtful we will do anything that spends money," she said, but she cited patent reform and trade deals as policies that could spur growth.