Posted by: Dirk | February 24, 2008

The Fed: Monetary policy without effect (?)

Martin Feldstein wrote an article at the WSJ saying that maybe it was unwise to use monetary policy now (well, in January) since it doesn’t have traction. In his words:

The dysfunctional character of the credit markets means that a Fed policy of reducing interest rates cannot be as effective in stimulating the economy as it has been in the past. Monetary policy may simply lack traction in the current credit environment.

This is no new argument, actually I remember Paul Krugman bringing it up at the New America Foundation conference in October 2006. The text is found at the Economist’s View. Here’s the main point:

The thing to be worried about is the difficulty of a policy response. We normally count on the Fed to respond. (Bernanke, on the whole, has had his judgment on rates vindicated.) But if this turns nasty, what will the Fed do? They will cut rates. And will this help? Where is the traction on the real economy? The problem is that rate cuts stimulate the economy mostly through the housing and construction market. In truth, business investment is not sensitive to the Fed and consumers don’t respond. Housing is where the rubber meets the road. So that is a worry.

If expectations are not influenced by the change in the interest rate, monetary policy will not work. According to Paul Samuelson even if monetary policy would work, there remains a big problem:

Today, central bankers and U.S. Treasury cabinet officers cannot know whether current interest rates are too high or too low. This is surprising, but true. The safest bond interest rates are indeed low. But financial panic engendered by the burst bubble of unsound U.S. and foreign mortgage lending means that even a mammoth corporation like General Electric would find it expensive now to finance a loan needed to build a new and efficient factory.

The situation is not hopeless. New, rational regulations that discourage predatory lending and rash borrowing could help a lot. Also, as we learned during the Great Depression, the government’s treasury and its central bank must be both the lenders of last resort and the spenders of last resort. Speculative markets will not stabilize themselves.

I have nothing to add to this.

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