Bankruptcy

The Fed Cannot Do it All

By Christian E. Weller

Many wait for Ben Bernanke and his colleagues at the Fed to save the economy from further turmoil. The reality, though, is that monetary policy is limited in addressing the crisis. In particular, the economy is slowing because the housing boom is over, which was caused and fuelled by deteriorating mortgage quality that resulted from people no longer paying their mortgages. The rise in foreclosures followed higher interest rates on resetting adjustable  rate mortgages, lower incomes in a weakening labor market, and declining home prices that put many mortgages ?under water?. Monetary policy can only directly impact interest rates and even there its reach is limited.

Monetary policy only targets short-term rates. Other interest rates should follow suit if the fed funds rate goes up or down. But, when the Fed cut short-term rates in late-2000, mortgage rates did not enter a prolonged slide for another 15 months. The same happened, when the Fed raised rates starting in mid-2004, it took another 14 months before mortgage rates went up slightly. This time around, mortgage rates followed the fed funds rate down, but mortgage rates have started to go up again over the past month, despite a reduction in the federal funds rate of 1.25 percentage points.

The Fed also doesn?t have as much room as in the past to cut interest rates. In 2000 and 2001, the Fed cut rates by 5.5 percentage points to get the economic effects it was looking for. This time, a 5.5 percentage points cut would mean that the short-term rates would have to turn negative. The potential reach of monetary policy is more limited to begin with.

Moreover, lower interest rates directly impact the supply for money and indirectly the demand for money. As the price for money falls, people should demand more. But many families already have enough debt and will not borrow more, no matter how low the price. The same holds for businesses. Without stronger sales growth, there is no reason for them to borrow more money to invest in factories that will produce things that nobody will buy. If lower interest rates will not translate into stronger consumption and investment, the demand for debt will likely not increase.

And finally, the Fed cannot tell lenders that the cheaper money should predominantly flow into the mortgage market, where the crisis hit hardest. There is no telling if lower interest rates will lead to more home purchases and to a stabilization of house prices. With the Fed having only a tentative direct effect on the primary causes of the immediate crisis, it seems high time to consider the other two tools - fiscal policy and regulatory policy ? more seriously and to design a real economic recovery plan in addition to the current economic stimulus program.

Full post as published by Credit Slips on February 20, 2008 (boomark / email).