Menzie Chinn thinks about the Federal Reserve's position:
Econbrowser: The U.S. Macroeconomy: Facing the Future with (at least) One Hand Tied: What about monetary policy? It is an economic truism that you cannot hit two separate target variables with one instrument. With fiscal policy hamstrung, monetary policy needs to make tradeoffs in order to hit inflation and output targets. If energy prices continue their slide, it may be that monetary policymakers will have the leeway to drop the Fed Funds rate. But if, for instance, energy prices do not continue their fall, or a decline in the dollar's value leads to a rise in import prices, then the Fed will be forced to choose between inflation stabilization and output stabilization. With Ben Bernanke at the helm, I think I know on which side he would err.
In fact, the choice may be more painful than what I have suggested in this scenario. In the wake of the dot-com collapse, monetary policy was successful in spurring economic recovery by encouraging a massive boom in residential investment. With the stock of housing at the end of last year 45% larger than it was at the end of 2001, it is not clear that a repeat performance is possible.
What I see as one possibility for monetary policy to work is by way of facilitating the shift of labor and capital to the export and import-competing sectors (mostly manufacturing, and some services). Expansionary monetary policy could accelerate the dollar's decline, and lower interest rates might result in stimulating higher investment in plant and equipment in those sectors so that we avoid a recession. How a sharp descent in the dollar will affect economies abroad remains an open question.
Now, several studies have documented the fact that in the past, large current account imbalances in industrial countries have usually been unwound with few serious consequences to either output or asset prices. But I have to stress, these are uncharted territory. The textbook model I laid out above may not apply this time around. By virtue of the fiscal and monetary policies of the last five years, the U.S. is ever more dependent on foreign capital inflows to determine interest rates; and indeed the United States is as dependent as it has ever been (at least in the post-War era) on foreign official or quasi-state -- not private investor -- financing. How all the ties binding the world's single largest economy will be unwound is something nobody can be certain of. What we can be certain of is that the choices made by policy makers in the past five years have circumscribed our ability to manage a downturn.