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Sunday, July 18, 2010

Don't Expect Miracles from Monetary Policy

A recent post of mine at MoneyWatch:

Don't Expect Miracles from Monetary Policy, Maximum Utility: ...As I've said many times, I think the economy needs more help, particularly labor markets. But where will that help come from? Additional fiscal policy seems to be off the table due to worries about the deficit, worries I think are baseless, but I don't control the fiscal policy levers. That's the best thing to do right now, but it's not going to happen.

That leaves monetary policy, and the Fed is making noises about giving the economy more help. Though the Fed isn't willing to go this far yet, one thing they could do is to purchase long-term securities in an attempt to lower long-term interest rates. Or they could set a higher inflation target to try to lower long-term rates. The idea is that this will spur investment spending by businesses and new spending on durables by households.

Paul Krugman, in a relatively wonkish post, discusses the options the Fed has, and notes that when it comes to the purchase of long-term securities (also known as quantitative easing), we shouldn't expect too much:

But how strong would this effect be? Even if the Fed bought a couple of trillion dollars’ worth, probably not all that large. I’m not saying don’t do it, but don’t expect miracles.

He doesn't explain in detail why we shouldn't expect much, but here's the worry I would have. Lowering interest rates either through purchases of long-term securities or through a higher inflation target (another policy Krugman discusses) is just the first step in this policy, and some of the additional steps that are needed are problematic. With respect to the first step, there's no guarantee that the purchase of long-term securities will lower long-term rates, but most analysts think it could if it is carried out on a large enough scale (the necessary scale -- trillions -- is is one of the things causing resistance to this policy). So let's assume the Fed can lower rates by a point of two if it so desires, either through quantitative easing or through a higher inflation target.

For the policy to be effective, there is a second step that must occur. Firms and households must respond to this incentive by investing more in new plants and equipment and purchasing more durable consumer goods. But as this discussion at The Economist I took part in notes, firms are saving rather than investing right now, and the reason seems to be due to a poor outlook for the economy along with considerable existing excess capacity. Under those conditions, a poor outlook and lots of excess capacity, a point tor two fall in the interest rate is unlikely to spur much new activity (and households, who are still struggling with high unemployment rates, are unlikely to increase their purchase of durables enough to make up the difference). So I fully agree with Krugman. We should try this, the state of the economy demands that we try something even if it may not work, but we shouldn't expect miracles.

    Posted by on Sunday, July 18, 2010 at 09:13 AM in Economics, Fiscal Policy, Monetary Policy | Permalink  Comments (24)


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