Saturday, January 26, 2008

Why Monetary Policy Has Already Used Up its Ammunition

The reality of a new fiscal stimulus package has led to much discussion about the proper type of fiscal stimulus during a recession (See here, here, and here). A key concern raised in this debate by some observers is that the past budget deficits under the Bush administration have used up of much of the ammunition fiscal policy would otherwise have had during a recession. Now The Economist makes a similar argument for why monetary policy stimulus may not be as effective this time around: it has used up much of its ammunition (i.e. monetary policy transmission channels) from being too loose and accommodative over the same time period.

"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...

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."

Nicely put. Read the whole thing.

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