This is the first part of a two-part op-ed published in the Fiscal Times. The second part outlines the specific actions that the Fed can take to ward off deflation and avoid a deepening of the current economic slump.
Skeptics who question the effectiveness of monetary policy come in two types. Some argue that the Fed's extensive efforts to bolster the economy over the past couple of years simply have not worked. Others think that these efforts have helped us weather the economic storm, but that would not be helpful or possible for the Fed to do more.
I am not persuaded by the arguments in either case, and, in a two-part posting, I will explain why. Today, I will take on the view that past monetary policy has been ineffective; next week, I will turn to options the Fed has for the future.
The Fed has taken aggressive steps to bring down interest rates in order to combat the deep slump in the economy that followed the financial crisis. The Federal Open Market Committee has used both traditional policy-lowering the federal funds rate to near zero in 2008-and nontraditional policy tools-most notably its 2009-2010 program to purchase up to $1.75 trillion in mortgage-related securities and U.S. Treasury securities. The effectiveness of the former is supported by an abundance of academic studies, and more recent work presents evidence of the importance of the latter. Yet critics contend that we would not be seeing such a slow and uneven recovery had monetary policy worked as intended.
The problem with this argument is that the poor performance of the economy that followed the financial crisis was neither unexpected nor unexplained. A 2009 analysis of historical financial crises by Carmen Reinhart and Ken Rogoff found that crises are typically followed by "profound" declines in economic activity. Further, the enthusiasm that greeted what appeared to be the end of the recession last year was tempered by a fairly widespread belief among analysts that important structural problems in the economy would make for a sluggish recovery. Financial institutions remained fragile, housing was still in substantial oversupply, and households needed to deleverage and save in order to rebuild the wealth they lost through falling home and equity values.
Recent economic news has been of particular concern because what economic momentum we had earlier this year seems to be waning. Real GDP growth slipped from 5 percent in the fourth quarter of 2009 to 3.7 percent in the first quarter of 2010 to 2.4 percent in the second quarter of 2010. In addition, monthly indicators like employment and retail sales growth have softened considerably since spring.
However, this slowing has a likely explanation. Temporary forces, mostly notably fiscal stimulus and firms' efforts to rebuild the inventories they drew down during the recession, have been providing important support to the economy. The hope had been that these factors would spur greater household spending and business hiring and investment so as to jumpstart a self-sustaining recovery. The recent indications that such optimism was mistaken may be a disappointment, but they do not speak to the potency of monetary policy.
All told, the depth of the recession and the rocky recovery hardly demonstrate that the Federal Reserve's efforts to date have not worked, as much as they are evidence of just how significant the economic headwinds have been. In other words, without these actions, things would have been much worse. In my next posting, I will turn to the question of what the Fed might do going forward to bolster the economy, particularly if incoming information continues to depict a recovery that is on shaky footing. With its short-term policy rate still close to zero, the Fed will need to deploy different measures that influence the interest rates facing consumers and businesses.