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Michael Brandl > Macro Updates > Archives > June 1, 2003 September 23, 2004 Sometimes it’s what you say not what you do…The traditional tools of monetary policy in the United States include targeting the Fed Funds Rate, setting the discount rate, and general manipulation of bank reserves. Over the last year or so there has been unveiled a new powerful “non-standard” policy tool of the Fed: words. In July of last year the Fed had cut short term interest rates to 45 year lows. Many pundits feared that the Fed was “running out of tools” and that economy would soon fall into a liquidity trap. Liquidity traps, if they exist, render monetary policy useless in guiding the economy since interest rates are near or at zero. When this happens the Fed, or any central bank, is powerless to end recessions, so the argument goes. But as is usually the case with economic dooms-dayers, they were wrong. Instead of changing interest rates, the Fed set out to change expectations by changing the way it communicates. Starting the summer of 2003 the Fed started making public statements about how it might change interest rates over the very near term: six to eight weeks. In August of 2003 the Fed stated that it believed it would keep interest rates unchanged for “a considerable period.” Okay…thought the bond market, interest rates will remain constant. Guess what happened? Longer term yield fell. In January of 2004 when the Fed changed its language from “a considerable period” to “patient in removing it policy accommodation” this set the stage for interest rate increases. Again in May 2004 the Fed stated it would remove the “accommodation at a pace that is likely to be measured.” The effect of all of this that it has gotten the attention of bond market participants. A recent study headed up by current Fed Governor Ben Bernanke (Bernanke, Reinhard and Sack “Monetary Policy Alternative at the Zero Bound: an Empirical Assessment,” Federal Reserve Board of Governors Finance and Economics Discussion Series, 2004, no. 48) has shown that these “non-standard” policy alternatives can be very effective. By choosing its words carefully the Fed could impact interest rates other than the one’s it sets directly. The outcome of the study suggests that central banks and the Fed in particular, still have many tools to guide the economy even when short term interest rates are near zero. So watch what the Fed says as closely as you watch what they do. Global Asset Bubble in Housing? The International Monetary Fund recently released a report where they argue that asset bubbles in housing prices are happening around the world. Specifically they point to UK, Australia, Ireland and Spain as examples of where prices of houses have increased dramatically over the past 8 years. The IMF argues that these price increases are growing faster than incomes, or rent prices. They worry that if the asset bubble implodes it could negatively impact the world’s economy. The solution for this the IMF suggests is for central banks to raise interest rates (seems like this is the IMFs solution for everything), and to reduce level of bank lending. Interestingly they did not suggest building more houses. All the best, MB |
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