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Wednesday, September 12, 2007

Martin Feldstein: Liquidity Now!

Martin Feldstein says it's time to begin lowering the federal funds rate "substantially"

Liquidity Now!, by Martin Feldstein, Commentary, WSJ: The time has come for the Federal Reserve to cut the federal funds interest rate substantially, starting on a path from the current 5.25% to 4.25% and possibly even less. Without such a policy shift, the U.S. economy faces the risk of a significant economic downturn.

Three separate but related forces are now threatening economic activity: a credit market crisis, a decline in house prices and home building, and a reduction in consumer spending. These developments compound the general weakening of the economy earlier in the year, marked by slowing employment growth and declining real spendable incomes. ...

Fed action to lower interest rates cannot solve the credit market problems, but it would help the economy: by stimulating the demand for housing, autos and other consumer durables; by encouraging a more competitive dollar to stimulate increased net exports; by raising share prices to increase both business investment and consumer spending; and by freeing up spendable cash for homeowners with adjustable-rate mortgages.

A reduction of the federal funds rate would not be a bailout for individual borrowers and lenders who are suffering from their past mistakes. Any such targeted bailout would be wrong, encouraging more reckless behavior in the future. But it would also be a mistake to resist an interest rate cut and risk a serious economic downturn merely to avoid the indirect effect of helping those market participants. ...

Although the extent of the possible decline in economic activity is uncertain, the economy could suffer a very serious downturn if the triple threat from the credit market, housing construction, and consumer spending materializes with full force. A sharp reduction in the interest rate would attenuate that very bad outcome. ...

Setting the federal funds rate requires a balancing of risks. If the economy would have continued to expand in the absence of a large rate cut, Fed easing now would produce an unwanted rise in inflation, an unwelcome outcome but the lesser of two evils. If that happens, the Fed would have to engineer a longer period of slow growth to achieve price stability. The economic cost of reducing that inflation would depend on the Fed's ability to persuade the market that easing under current conditions is an appropriate risk-based strategy and not an abrogation of its fundamental duty to pursue price stability.

    Posted by on Wednesday, September 12, 2007 at 12:24 AM in Economics, Monetary Policy | Permalink  TrackBack (1)  Comments (52)


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