Out of ammo?

A recent article by Justin Lahart in the Wall Street Journal raises the possibility that the Fed will run out of tools for combating the unfolding financial crisis, and incipient recession.

A lot of this is reminiscent of the discussion back in 2003 – and that discussion was of course reminiscent of the discussion of the tools that were available to the BOJ, but generally left unused. With the funds rate then down at 1%, and people were paying a lot of attention to “unconventional” monetary policy. Bernanke, then a member of the Board of Governors, even at one point suggested targeting or somehow influencing long-term bond yields. Two possibilities were being kicked around: (1) large-scale purchases of long-dated securities with no set targets, and (2) explicit targets for long-term term interest rates, like those in place before the Accord. Purchases of private-sector obligations were also being discussed, but there was some concern that this would overstep the Fed’s legal bounds. (A 2004 Fed working paper by Small and Clouse thoroughly reviews these constraints.) Nothing was ever done along these lines, but drawing on a highly influential paper by Woodford and Eggertsson, the FOMC eventually inserted the famous “considerable period of time” clause into its statement. It would be interesting to know whether any of these options are being dusted off.

There are some obvious similarities between now and 2001-03: (1) the weak real economy, and (2) the collapse of asset prices (stocks then, housing now).

But there are a couple of important differences too: (1) inflation pressure and the spike in commodity prices, and (2) the fragility of the financial system. In 2003, we were able to reassure ourselves that we were not “turning Japanese” because at least the financial system (banks in particular) seemed to be in good shape. Today, banks generally seem to be OK, at least for now – it’s everything else that seems to be coming apart. These are greatly complicating the Fed’s job: If it were just a soft economy and falling inflation, the Fed’s task wouldn’t be easy, but at least it would be relatively straightforward.