Question

The Federal Reserve has pushed short-term interest rates down to almost zero and has claimed it will purchase almost any amount of commercial paper. What is the Fed trying to accomplish with these policies. What is the downside potential?

Answer 1

Keeping short term interest rate to zero and agreeing to purchase commercial papers by the Federal reserve is a measure to tackle the current economic crisis that has occured due to Corona pandemic. The Federal Reserve has followed similar strategy during the Economic crisis of 2008 as well.

Due to the corona pandemic, the economy has fallen to a new low in recent times, Oil price hit a new low, the business and new investments has reduced drastically. Due to this issue the unemployment is projected to increase and deflation can happen. As most of the economists believe a controlled level of infaltion and reduction in unemployment are important parameter for a growth in economy.

To maintain the same, by keeping almost zero interest rate, Federal reserve is expecting to reduce savings by the institutions, people and pump more money to the market to increase the liquidity. This also provide new loans to struggling businesses.

The downside potential of this decision can be high level of inflation if unchecked once the economy reverse its trend.This also can lead to liquidity trap and can severly affect the banking sector as there will be significant reduction in interest income.