The Fed Still Has Plenty of Ammunition
Don't believe critics who say that monetary policy is not an effective tool.
By FREDERIC S. MISHKIN
There is a common view that the Federal Reserve's monetary policy has been ineffective, akin to "pushing on a string."
Aggressive monetary policy easing during the recent financial crisis has, after all, been unable to lower the cost of credit
or increase its availability to households and businesses.
This view has been expressed in a number of op-eds, and also by some members of the Federal Open Market Committee. This
perspective is dangerous because it leads to the conclusion that there is no reason to use monetary policy to cope with the
current crisis; all that aggressive easing of monetary policy does is weaken the credibility of the central bank with regard
to inflation without stimulating the economy.
Is this true? To see why the opposite is the case and why aggressive monetary policy easing is called for, ask yourself:
What if the Fed had not cut rates during the current crisis?
Tighter monetary policy -- by restraining consumer spending and business investment -- would have made it more likely
that the economic downturn would be even more severe, which would result in even greater uncertainty about asset values. Tighter
monetary policy would then have made an adverse feedback loop more likely: The greater uncertainty about asset values would
raise credit spreads, causing economic activity to contract further, thereby creating more uncertainty, making the financial
crisis worse, causing the economic activity to contract further, and so on.
If the Fed had not aggressively cut rates, the result would have been both higher interest rates on Treasury securities
and a substantial increase in credit risk on other assets. Interest rates relevant to household and business spending decisions
would then have been much higher than what we see currently.
In short, not only has monetary policy been effective during the current financial crisis, it has been even more potent
than during normal times. That's because it not only lowered interest rates on Treasury securities but also helped lower the
spread between Treasury bonds and riskier assets.
This does not mean that monetary policy alone can offset the contractionary effect of the current massive disruption in
the credit markets. The financial crisis has led to such a widening of credit spreads and tightening of credit standards that
aggressive monetary policy easing has not been enough to contain the crisis. This is why the Fed and other central banks have
provided liquidity support to particular sectors of the financial system.
Even though the Fed's liquidity injections, which have expanded the Fed balance sheet by well over a trillion dollars,
have been extremely useful in limiting the negative impacts of the financial crisis, they have not been enough. A fiscal stimulus
package is needed to keep the U.S. economy from entering into a deep recession. The $500 billion question is whether the fiscal
package can be done right so it has the maximum impact in the short-run but does not lead to future tax burdens that are unsustainable.
The fact that monetary policy is more potent than during normal times argues for even more aggressive easing during financial
crises. By easing aggressively to offset the negative effects of financial turmoil on economic activity -- this includes cutting
interest rates preemptively, as well as using nonconventional monetary policy tools if interest rates fall to zero -- monetary
policy can reduce the likelihood that a financial disruption might set off an adverse feedback loop. The resulting reduction
in uncertainty can then make it easier for the markets to value assets, hastening the return of normal market functioning.
Aggressive easing of monetary policy poses the danger that it might destabilize inflation expectations, which could then
lead to a significant rise in inflation in the future. How can the Fed keep inflation expectations solidly anchored so it
can respond preemptively to financial disruptions? It needs to communicate that it will be flexible in the opposite direction
by raising interest rates quickly if there is a rapid recovery in financial markets, or if there is an upward shift in projections
for future inflation. In this way the Fed can show that it is prepared to take back some of the insurance it has provided
by its earlier monetary-policy easing.
The most dangerous aspect of the belief that monetary policy is ineffective during financial crises is that it may promote
policy inaction when action is most needed. If anything, monetary policy makers must respond rapidly during financial crises
because aggressive monetary policy easing can make adverse feedback loops less likely.
Mr. Mishkin is a professor of finance and economics at the Graduate School of Business, Columbia University, a former
member of the Board of Governors of the Federal Reserve system, and the author, most recently, of "The Economics of Money,
Banking, and Financial Markets, 9th Edition" (Pearson/Addison-Wesley, forthcoming).