Is monetary policy still a potent weapon against recession?

Is monetary policy still a potent weapon against recession? WRITING in Slate magazine in 1997, Paul Krugman, an American economist, neatly captured the widespread belief in the omnipotence of the then-chairman of the Federal Reserve. “If you want a simple model for predicting the unemployment rate in the United States over the next few years, here it is: it will be what [Alan] Greenspan wants it to be, plus or minus a random error reflecting the fact that he is not quite God.” Faith in the Federal Reserve is not what it used to be. Since September the Fed has cut its policy rate by 1.75 percentage points, to 3.5%. It still has plenty of firepower left—rates are some way above the 1% level reached in 2003—but few seem willing to rely on monetary policy alone to save the day. Politicians and pundits alike were making a case for a fiscal stimulus package even before the Fed's surprise rate cut on January 22nd. That Ben Bernanke, the Fed chairman today, has given his blessing to the plan only adds to the impression that central banks have lost their grip. What lies behind this loss of faith? One cause is the feeling that overly loose monetary policy got the economy into this mess. Repeated cuts in interest rates during the last downturn, in 2001-03, fuelled the housing and credit bubbles that are now bursting to such damaging effect. The legacies of that boom—falling asset prices, high consumer debt and bank losses—may now hamper the ability of central banks to prop up spending. One of the ways that central banks affect the economy is through their influence on the price of assets, like shares or homes. Other things being equal, a reduction in short-term interest rates should bump up asset values, because their stream of future earnings is discounted by a smaller factor. Now that America's housing boom is ending, the worry is that the Fed is less able to stimulate the spending that comes with rising housing wealth. Assets are already dear, it is said; there are no bubbles left to reflate. Falling home prices make for a nation of savers, not shoppers. And firms are not keen to invest when the market value of their assets is shrinking. Falling asset prices hurt the market for credit too, interfering with another policy channel. Monetary policy affects the choice between spending now or spending later and, for the cash-strapped, credit provides the bridge from the present to the future. Interest rates are the cost of using tomorrow's income to pay for today's spending. Lower rates lift spending by more when there is access to borrowing. Firms and homeowners can borrow cheaply with good collateral, but funds are less abundant when asset values are falling. Consumers may in any case have had their fill of borrowing. Household debt in America has vaulted to more than 130% of disposable income from less than 100% in 2000 (see left-hand chart). In Britain the ratio is higher still. And even if credit demand holds up, banks reeling from subprime-related losses are less willing to supply it. Another strain of policy pessimism argues that interest-rate cuts will only fuel inflation, without helping the economy. In fact it seems likely that America's economic slowdown will create enough slack to ease inflationary pressure. That, at any rate, seems to be the judgment of the bond markets. In the months since the Fed's first rate cut in September, ten-year bond yields have dropped steadily, in contrast to the reaction to the rate cuts in early 2001, when bond yields drifted upwards (see right-hand chart). The distant sound of whirring rotors Central banks are not toothless, however. They can still affect spending by altering the returns of existing savers and borrowers. Lower interest rates increase the disposable income of debtors, by cutting their repayments, even as they eat into savers' cashflow. Borrowers are likely to spend more out of each additional dollar, so tilting the scales in their favour by cutting rates should boost demand. In America the household sector's debt has grown faster than its stock of interest-bearing assets, so the cashflow channel is now likely to be more, not less, powerful. The effect is probably stronger still in countries such as Britain and Spain, where most mortgage rates are closely tied to policy rates or fixed for only short periods. Although the asset-price and credit channels are more constricted than in the past, monetary policy can still work through them. Interest-rate cuts are unlikely to lift house prices, but they may at least arrest the size and pace of price falls. The firms and households that are less burdened by debt will be able to take advantage of lower interest rates, even as others are struggling to reduce their borrowing. If the Fed still has some clout, why the clamour for fiscal stimulus? In an election year, politics is one obvious factor, but economic arguments can also be brought to bear. One attraction is that it eases the over-reliance on monetary policy. Alan Blinder, a Princeton professor and former Fed governor, also argues* that fiscal remedies can boost demand more quickly than interest-rate cuts. Tax breaks work well if they bring spending forward, say by targeting help on the poor, who are more likely to spend than save—though this may be hard to arrange in practice. The drawback is that it leaves decisions to politicians, who risk taking too long to agree on the right policies in a slump and are unwilling to raise taxes in a boom. Although monetary policy is normally best placed to help stabilise the economy, there are some circumstances where fiscal policy can help—during long or deep recessions, when demand suddenly slumps, or when interest rates fall to zero. In the latter case, writes Mr Blinder, “a combined monetary-fiscal effort—deficit spending or tax cuts financed by printing money—may be needed”. This is Milton Friedman's “helicopter drop” of money. Only then will the Fed really start to feel impotent.