Given the current panoply of worries—the housing crunch, rising oil prices, decreased consumer spending, depressed corporate profits, and slowing growth in Japan and Europe—most economists appear to welcome such a move. Harvard’s Martin Feldstein summed up the conventional wisdom last month when he said the federal funds rate should drop to 4.25 percent or less in order to prevent a significant economic downturn.
Not so fast. While it is true that substantial housing crises have often presaged a recession, the U.S. economy still has considerable strengths and solid growth prospects. What matters now is that monetary policy be oriented toward sustainable economic growth—which is to say, we need a policy that acknowledges the long-term linkage between sound money and solid, sustainable growth. Financial markets—and economic agents—are highly efficient at discounting the future into the present, and they will react positively if the Fed moves to defend the dollar’s value and stability.
Chapman analyzes the how we got in this current Fed induced mess:
Consider the present environment. From late 2001 to 2004—in the wake of a global recession, terrorist attacks, and war—U.S. monetary policy pursued a dramatic reduction in short-term interest rates. Indeed, for much of that period the real federal funds rate was negative. When interest rates are artificially held below their natural level, investors get false signals, particularly in interest-sensitive capital goods sectors, such as housing and construction, which experience a boom. The falsified interest rates induce a flurry of lending and investment in capital goods, and hiring and spending increase in these sectors. Conversely, financial institutions, which now have an excess of reserves to lend due to the Fed’s expansionary policy, seek out borrowers of dubious credit. For several quarters, or even years, a general economic boom occurs.
But the housing and capital goods booms—along with the loans to marginal borrowers—are not based on real savings. Rather, they are based on a spike in fiduciary credit triggered by Fed policies that inject reserves into the banking system to cut interest rates and fuel the boom. As such, some increases in spending and employment are unsustainable, and marginal projects undertaken without the backing of real demand may face insolvency.
Eventually the central monetary authority faces a dilemma, which is roughly where we are now. It can compound its errant intervention by accelerating the expansionary policy, keeping interest rates below where they would be otherwise. Or it can allow interest rates to return to their natural levels and thereby cause an economic slowdown, as marginal projects are liquidated, assets are repriced, and labor markets readjust.
As dislocations deepen, postponement usually makes the eventual correction more painful. But a bigger problem with continued monetary ease is the loss of confidence in the Fed’s commitment to protecting a strong American dollar. Given that the dollar serves as a global reserve currency, a flight from dollar-denominated assets abroad could mean a return to 1970s-style inflation and global recession.
As I have said a number of times, our problems are a result of bad monetary policy. They won't be solved by more bad monetary policy.
It would be interesting to see what Mr. Chapman's view of the economy is now. I'll see if I can contact him at AEI and invite him to participate on the blog.