The Fed Still Has Plenty of Ammunition
Two questions: How effective has Federal Reserve policy been over the past fifteen months? And how effective can Federal Reserve policy be looking forward?
Rick Mishkin's view:
The Fed Still Has Plenty of Ammunition: 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 perspective is dangerous because it leads to the conclusion that... 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?... [A]sk yourself: What if the Fed had not cut rates during the current crisis?... 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.... [N]ot only has monetary policy been effective during the current financial crisis, it has been even more potent than during normal times.... 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.... 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....
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 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...
