The Mystery: Why and How Does Monetary Policy Rule the Economy?
The interest rate on overnight loans of federal funds is, as explained above, the Fed’s instrument of
policy. It is a market rate, which the Fed controls by buying or selling Treasury bills (in usual practice
with agreements to repurchase them) at its intervention rate, nowadays publicly announced. At
scheduled meetings eight times a year — and occasionally at other times — the Federal Reserve
System’s “Federal Open Market Committee” (FOMC) reconsiders and sometimes changes the intervention
rate, generally by 25 or 50 basis points, rarely by more.
The tail wages the dog. By gently touching a tiny tail, Alan Greenspan wags the mammoth dog,
the great American economy. Isn’t that remarkable? The federal funds rate is the shortest of all
interest rates, remote from the rates on assets and debts by which businesses and households finance
real investment and consumption expenditures counted in GDP. Why does monetary policy work?
How? It’s a mystery, fully understood by neither central bankers nor economists.
There are two lines of explanation: substitution chains and policy expectations. Expectations are
very powerful, but they cannot work unless chains of asset substitution really do occur. That is,
FOMC actions today, in conjunction with other economic observations, convey information about
future monetary policies and future federal funds rates and thus affect the entire current spectrum of
interest rates and asset prices. The process involves reshufflings of portfolios in response to changes
in market interest rates and asset prices, actual and expected: banks’ reserves and loans; bank deposits,
bonds, and equities; debt instruments, equities, and real properties.
It would do portfolio managers, entrepreneurs, and consumers no good to understand Alan
Greenspan if his actions really do not matter — unless they matter just because everyone thinks they
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do. We think we know that monetary policy is not just a bubble. We think we know from experience,
as in 1931–33, 1973–74, 1979–83, that the Fed can if it wants take really big actions with immense
consequences, and these demonstrations support the belief that even its modest everyday measures are
important. That belief makes the central bank’s job much easier. But it does not permit us, or the
central bank, to expect precision from formula rules like Taylor’s, as good as his is.
Why do the Federal Reserve and other central banks intervene only in financial markets for the
shortest and most liquid nominal assets, those closest to the monetary base, far from the frontiers
between financial markets and economic agents’ expenditures on GDP goods and services? It was not
always thus. In the past, central banks have discounted illiquid commercial loans, and even brokers’
customer loans, and have conducted open market operations in long-term government bonds. In the
present free-market mood of capitalist democracies, central banks want to be as unobtrusive and
neutral as possible.
However, there are times when interventions closer to the real economy would be desirable. The
present impasse in Japan is an example. Central bank operations in short safe liquid assets are mired
in the “liquidity trap.” Because of the unfavorable and risky business outlook and the unsound balance
sheets of the banks, loans to businesses and households are expensive or unavailable. The Bank of
Japan has operated in the stock market in the past, and maybe the time has come again for bold moves.
More generally, operations in long-term bonds could help get cyclical recoveries going when
lenders are slow to reflect easing of short-term rates. Inflation-indexed government bonds are
desirable instruments for open market operations, because they are closer to real goods and services
than are nominal bonds. With fiscal policies no longer eligible for counter-cyclical stabilization, and
with the globalization of financial markets threatening national financial sovereignty, innovative
thinking about the tactics and structure of monetary operations is urgently needed. This is especially
imperative in Europe, given the novel challenges facing the new EU central bank.
References
Taylor, J. B. (1993), “Discretion versus Policy Rules in Practice,” Carnegie–Rochester Series on
Public Policy 23, 194–214.
Tobin, J. (1983), “Monetary Policy Rules, Targets, and Shocks,” Journal of Money, Credit, and
Banking 15, 506–18.
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