While some critics believe the Federal Reserve overreacted by increasing the discount rate in February, a Fed economist said the nation's central bank made the move to avoid reliving the inflation-plagued 1970s.
"We got burned three times in the 1970s and have learned that monetary policy must respond early," Jack Beebe, senior vice president and director of economic research for the Federal Reserve Bank of San Francisco, told the Deseret News.Beebe met with local news media and directors of the San Francisco bank's Salt Lake City branch on Thursday.
At its February meeting, the Fed's board of governors decided not to immediately raise the discount rate but to advise the treasury bill traders in New York that if inflation rises, so will the discount rate.
Indeed, within two weeks, the discount rate - which the Fed charges its member banks for borrowing - shot up a half percentage point to 7 percent, following a report on January's rising wholesale and retail prices.
"The Fed responded to keep it (inflation) from getting out of hand," Beebe said.
Discussion before the decision was intense, he explained, as some Fed bank presidents, including Robert Parry of San Francisco, wanted the discount rate raised immediately and others believed there was more time to make the move.
Beebe noted that the inflation of the late 1970s occurred in part because the Fed waited too long to cool inflation. When the Fed didn't act, inflation continued to heat up and the market showed its lack of confidence in Fed policy by increasing long-term interest rates.
But this latest move in raising the discount rate won approval from the nation's security markets, Beebe claimed.
"The fact that short-term rates rose 3 percent, inflation 1 percent and long-term rates are holding constant reflects that the market believes in the Fed's response."
Explaining how Fed policy is made and how the discount and federal funds rates affect the economy, Beebe said monetary policy is made by the Federal Reserve's Board of Governors and the Federal Open Market Committee.
The board of governors sets the discount rate, while the federal funds rate - the short-term price banks pay to borrow from each other - is set by the Federal Open Market Committee.
In addition to relying on employment, sales, production and other statistics and indicators, the economic condition of each district is considered. Beebe said each district submits a report based on information from each branch bank within the district.
For example, the appointed directors of the Salt Lake branch, who represent various sectors of the business community, meet each month to report on conditions in their industry. That information is sent to the San Francisco district bank, where researchers collect data from all the branches and compile a report on the entire district.
"This gives us some grass roots data on current economic conditions," Beebe said.
The rates set by the Fed determine how much money is circulating throughout the economy and what interest rates will be charged to business and consumers.