Sunday, April 26, 2009

Fed to Remain Creative in Monetary Policy

Source: Financial Times, Fed Study Puts Ideal US Interest Rate at -5%

An internal policy analysis prepared for the Federal Reserve’s last policy meeting indicates that the ideal interest rate for the U.S. economy’s condition should be -5% (yes, that is a minus sign). The conclusion, while unrealistic in actual application, encourages the Fed to continue using unconventional policies to stimulate the economy.

The -5% projection is based on the Taylor Rule, which estimates an appropriate interest rate based on unemployment and inflation. Even though a central bank cannot cut rates below zero, the analysis indicates that the Fed should continue its unconventional policies that stimulate the economy that roughly equate to a -5% interest rate. Separate estimates indicate that the Fed would need to expand its asset purchased by more than the $1,150 billion increase that the Board of Governors approved at the Fed’s last meeting. The Fed is not expected to make any substantial monetary policy changes at its next meeting—especially in light of the fact that the economy is a bit stronger than it was during the last meeting—but is expected to brainstorm potential monetary policy changes at its next meeting. One option is the Canadian approach of setting an explicit timeframe for keeping interest rates at or around 0%, though that approach is subject to debate—some arguing that it is not credible and could be ineffective.

At its last meeting, the Fed purchased long-term treasuries for the first time in decades—and is keeping open the possibility of buying more if economic forecasts go down again. But policymakers will most likely watch how market interventions already underway affect the economy before implementing new policies.

Questions for Discussion:

In light of basic macroeconomic theory, is monetary policy creativity the right approach? Given the tools that the Fed has to control the money supply and the expansion or contraction of the economy, are the Fed’s hands tied if they don’t opt for creative solutions? Or should the Fed follow macroeconomic models and try to affect only one monetary factor at a time?

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