Kavan Choksi Wealth Advisor Talks About How the Federal Reserve Fights Recession

The Federal Reserve, commonly known as the Fed,  is the Central Bank of the United States. It has a dual mandate, to work to achieve low unemployment, as well as to maintain stable prices throughout the economy. During the recession, unemployment goes up and the prices may fall in a process known as deflation. As Kavan Choksi Wealth Advisor says, in the case of steep economic downturns, the Fed is likely to take steps to bolster prices and suppress unemployment.

Kavan Choksi Wealth Advisor briefly discusses how the Fed fights recession

Certain business starts to fail at the onset of a recession. This generally happens owing to a combination of economic bottlenecks or shocks caused by the incompatibility of consumption and production activities resulting from previously distorted interest rate and credit conditions. Such businesses may sell their assets, lay off workers, default on debts or may even go bankrupt. All of these factors tend to put a downward pressure on prices and the supply of credit to businesses in general, leading to a process of debt deflation.

Deflation that takes place in the form of falling prices is usually not harmful to the economy or a cause of concern for most consumers or businesses by itself. However, it is feared by central banks, and the financial sector at large, particularly when it involves debt deflation as it can elevate the real value of debts and thus the risk to debtors. In order to protect its constituent banks from defaulting on their overextended debts, the Fed takes steps to fight recession.

As per Kavan Choksi Wealth Advisor, the Fed may lower interest rates by purchasing debt securities on the open market in return for newly created bank credit. With an influx of fresh reserves, the banks from which the Fed makes purchases can lend money to each other at a reduced federal funds rate. The Feds aims for a drop in interest rates spreads throughout the financial system, so that lower interest rates are charged to individual customers and businesses.  The intended outcome is that lower interest rates make borrowing more affordable for companies, allowing them to incur additional debt instead of facing defaults or having to implement staff layoffs. This strategy serves to maintain current employment levels and mitigate the rise in unemployment during economic downturns. Furthermore, decreased interest rates empower consumers to engage in more credit-based purchases, sustaining high consumer prices and encouraging individuals to extend their financial commitments rather than adhering strictly to their means.

There are instances when interest rates reach a lower limit as banks retain the freshly introduced reserve credit for their internal use as liquid reserves for meeting debt obligations. During such scenarios, the Federal Reserve may opt to persist with open market operations, acquiring bonds and other assets to saturate the banking system with additional credit. This approach is termed quantitative easing (QE), involving the direct acquisition of assets by the Federal Reserve to infuse more funds into the economy and amplify the money supply.

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