The Credit Crisis and Monetary Policy

There have been a lot of complaints about the current monetary policy of the Fed and its apparent "lack-of" effect on the credit crisis. What many fail to realize is that without many of the recent monetary moves the credit crisis would be worse than it is now and worse than what it would be going forward. There are no rabbits to pull out of any hats. At this point it is all about making the patient more comfortable. The amrkets still have to go through all the pain. Text in bold is my emphasis. From the WSJ:

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.