Mishkin: Fed Policy Has Been Effective

Frederic Mishkin:

The Fed Still Has Plenty of Ammunition, by Frederic Mishkin, Commentary, WSJ: There is a common view that the Federal Reserve's monetary policy has been ineffective, akin to "pushing on a string." ... 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..., 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... Tighter monetary policy would ... have made an adverse feedback loop more likely...

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. ... 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. ...

Aggressive easing of monetary policy poses the danger that it might destabilize inflation expectations... How can the Fed keep inflation expectations solidly anchored..? It needs to communicate that ... if there is a rapid recovery in financial markets, or if there is an upward shift in projections for future inflation ... the Fed ... 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.

I don't think anybody (well, very few people anyway) advocated leaving interest rates at 5.25%, or that it was a mistake to ease policy once the full extent of the crisis was evident. My quarrel was always with the people who said let's wait to see if monetary policy works before we start thinking about implementing fiscal policy (e.g., or better, here). Monetary policy might be able to prevent severe downward spiral - it might be able to prevent the bottom from falling out and attenuate the downward fall some, but by itself it was very unlikely it would be enough to give the economy the boost it needs. If we waited to see if monetary policy works, and then find that it doesn't, it would then most likely be too late to implement fiscal policy without rushing things out the door, or it would be too late to do much at all.

Arguing we should wait to see if monetary policy works was not helpful. The two links above are from nearly a year ago, one is a discussion of infrastructure spending, and if we'd pursued fiscal policy seriously at that time - spending measures in particular - instead of relying upon the meager stimulus provided by one-shot tax rebates things might not be looking so bad today (which means, of course, we'd be hearing about how unnecessary the fiscal policy measures were, the health of the patient after taking the medicine would be used to argue that the patient was never really all that sick).