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July 21, 2008

We're Asking Too Much of the Fed

Glenn Hubbard
Dean and Russell L. Carson Professor of Finance and Economics
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The Fed’s rush of liquidity injections reflects Walter Bagehot’s classic Lombard Street advice to “lend freely.” One might ask, however, whether the successive liquidity injections at the onset of difficulty (as in the stock-market crash of 1987, the Long-Term Capital Management crisis of 1998 and the 9/11 attacks of 2001) have made market participants worry less about liquidity risk.

If liquidity intervention is inevitable, the central bank must be able to supervise and regulate the beneficiaries of its liquidity insurance. Otherwise, such insurance fans moral hazard by failing to discourage taking on still more liquidity risk (read: the most recent crisis). And making that insurance more available simply raises this concern (read: where we are now).

The events of the past three years highlight that risk misperceptions in a boom can lead to a scramble for liquidity if collateral values decline.

Importantly, Bagehot’s admonition goes on to say: “The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times.”

While strong supervision obviously remains important, this other advice from Bagehot would be an important addition to the policy tool kit. This could be implemented by raising banks’ capital requirements proportionately as risk-weighted bank assets grow. By varying capital cushions over credit cycles, consequences of risk distortions for actual lending and borrowing decisions will be reduced, along with the likelihood of asset fire sales and extraordinary central bank liquidity provisions.

Remembering Bagehot’s advice would give the central bank a way to deal with bank-lending bubbles. While a central bank’s tools may be poorly suited to prick bubbles like that of the information technology boom of the late 1990s, a bank lending bubble can — and should — be addressed.

The current policy stance of holding the federal funds rate at two percent will keep monetary stimulus in place. With inflationary expectations not declining, this stimulus will almost surely raise inflationary expectations as the economy improves. This consequence can be seen already in surging commodity prices and the weakness in the foreign-exchange value of the dollar.

It is worrisome that the Fed’s own 2008 projections have risen over the year both for headline inflation and core inflation. Furthermore, the Fed’s projections of receding inflation in 2009 and 2010 coming true will almost surely require increases in the federal funds rate.

A continuation of a negative real federal funds rate and the increase in money growth accompanying it raises the risk of increasing inflationary expectations, a costly mistake to fix.

It is asking a lot for monetary policy alone to carry the burden of supporting aggregate demand.

Fiscal policy can play a role. Congress and President Bush did pass an economic stimulus package centered on tax rebates. But clarity about a positive future for the 2001 and 2003 tax cuts which bolster collateral values — along with a cut in corporate tax rates to promote investment — would offer a much more potent tonic.

Access the full text of Dean Hubbard’s op-ed in today’s Wall Street Journal, available here.


by Tyler Mobley | July 21, 2008 at 4:48 PM

Are there any relevant case studies showing that the decision of a central bank to maintain negative real interest rates has carried a long-term cost that outweighed the near-term benefit of the monetary stimulus? Every media source I listen to seems to agree that increased inflationary pressure is undoubtedly a "costly mistake to fix." However, I don't often hear of any hard data (or relevant cases) that would help me to understand just how damaging a negative federal funds rate can be to long-term economic growth.

by R. Glenn Hubbard | July 23, 2008 at 10:38 AM

I would argue that the economic environment in the United States in the 1970s is itself a case study: At the time, the Fed held real interest rates low and inflation accelerated as a result. For further examples and data, see the monetary policy chapters in my textbook, Money, the Financial System, and the Economy, or in my colleague Frederic Mishkin's Economics of Money, Banking, and Financial Markets.

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