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Is U.S. Monetary Policy Really Too Loose?

Wednesday, September 3, 2008

The Fed shouldn’t hike interest rates until it has clear evidence of stabilization in the housing and credit markets.

A dangerous myth is making the rounds in policymaking and financial market circles. It says that the Federal Reserve has been overly accommodative in responding to the ongoing U.S. housing market and credit market busts, and that the Fed’s loose monetary policy has raised the specter of high inflation. The danger of this myth is that it could induce the Fed to repeat a mistake made by the Bank of Japan in the early 1990s—the mistake of prematurely raising interest rates at a time of acute financial market stress. 

Proponents of the idea that U.S. monetary policy is too loose include a number of Federal Open Market Committee members and regional Federal Reserve presidents. They focus their argument on the unprecedented rapidity with which the Fed has cut the federal funds rate from 5.25 percent to 2 percent between August 2007 and March 2008. They are quick to note that the federal funds rate now is considerably below the inflation rate (5.5 percent), which, they fear, could stoke inflationary expectations.

They also contend that the Fed has been overly generous in opening its discount window to both commercial and investment banks, pointing out that the Fed has accepted more than $500 billion in mortgage-backed securities as collateral for repurchase operations. Those mortgage-backed securities now represent more than half of all the assets on the Fed’s balance sheet. Critics insist that the Fed’s congressional mandate has been stretched to the limit, if not beyond.

Doesn’t the severity of the housing and credit busts suggest the need for a highly accommodative monetary policy?

What to make of these claims? The federal funds rate is indeed negative in real terms. However, before jumping to the conclusion that U.S. monetary policy has been too lax, other important questions must be addressed. For example: Has the reduction in the federal funds rate led to any meaningful reduction in the pertinent longer-term interest rates at which most households and corporations borrow? And doesn’t the severity of the housing and credit busts suggest the need for a highly accommodative monetary policy?

Critics of Fed Chairman Ben Bernanke overlook the fact that the Fed’s recent efforts to reduce borrowing costs have been largely offset by the intensification of the credit crisis. In response to that crisis, banks have demanded substantially increased spreads when lending to households and corporations. As a result, the interest rates paid today by households and corporations are generally no lower than they were last August, when the Fed began cutting the federal funds rate; in the case of mortgage loans, they are appreciably higher today than last August.

Households and corporations are also being hurt by the virtual freezing of the securitization market and by a major reduction in credit availability. Mortgage lending by private banks has all but dried up, and the Fed reports that around 60 percent of all banks have been significantly tightening their non-mortgage lending standards.

The upshot is that over the past year total bank lending has fallen by around 7 percent. This represents the fastest pace of credit contraction in 40 years, and it stands in marked contrast to the double-digit annual rate of credit expansion that we saw earlier this decade. Such a decline, coupled with marked deceleration in the broad monetary aggregates, indicates that U.S. monetary policy has not been excessively loose.

The credit crunch is occurring at a time when (as the Fed correctly notes) the downside risks to the U.S. economy have increased. Of particular concern are the rising tide of home foreclosures and the continued stresses in the financial sector, as exemplified most recently by the meltdown at Fannie Mae and Freddie Mac. Meanwhile, the effects of the federal tax rebate program, which provided the economy with crucial support in the second quarter, have already begun to fade, and there is growing evidence that Europe and Japan are on the brink of recession, which threatens future U.S. export growth.

In recent weeks, international oil and food prices have declined by over 20 percent—a direct response to slower global economic growth. This should ease inflationary expectations in the near term. Given the very real downside risks to the U.S. economy, the Fed should ignore its critics and refrain from hiking interest rates until there is clear evidence of stabilization in the housing and credit markets.

Desmond Lachman is a resident fellow at the American Enterprise Institute.

Image by Getty/Darren Wamboldt.

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