Over the past year and a half, the US federal funds rate has dropped from 4.75% to less than 0.25%. This implies significant monetary policy easing.
However, credit spreads since then have only increased, both for households and firms. Baa corporate bond rates have increased by over 200 basis points since September 2007, and interest rates on junk bonds have risen by over 1000 basis points. Credit standards have also been tightened in general, with overall lending dropping significantly. This begs the question of the effectiveness of this monetary policy intervention?with questions raised by academics, the media and even the Federal Open Market Committee. Is monetary policy ineffective in restoring financial stability because of the major and recurring shocks to credit markets?
Frederic Mishkin of the National Bureau of Economic Research (NBER) discusses this specific question in his recent paper ?Is Monetary Policy Effective During Financial Crises??. He argues that monetary policy is not just effective, but even more potent during financial crises?despite the increase in credit spreads.
To understand this argument, he expresses financial instability as sourced from two types of risk?valuation risk and macroeconomic risk. Valuation risk arises when markets find it difficult to price financial instruments due to high asymmetries of information and opacity in design. For example, many of the higher rated tranches of bonds were issued by CDO?s with sub-prime assets as underlying collateral. Given the sub-prime crisis, pricing of these bonds is now extremely difficult. Macroeconomic risk, on the other hand, measures the probability that this financial instability will have a real impact on the economy. An economic downturn leads to greater uncertainty about asset pricing, which spirals into greater financial instability and leads to a further downturn. This risk is therefore part of a vicious cycle named as the ?financial accelerator? by Ben Bernanke in 1989.
Mishkin explains that the differences between valuation risk and macroeconomic risk helps in understanding the effectiveness of monetary policy in a financial downturn. Monetary policy is primarily aimed towards reducing macroeconomic risk, since tighter or looser policy cannot affect the opacity of securities, nor can it lower or increase information asymmetries. Traditionally, looser monetary policy increases consumer demand and business investment, thereby reducing the impact of the financial downturn on the real economy. Given the financial accelerator mechanism, the greater the downturn, the greater the impact of monetary policy as a counter to the vicious cycle.
He takes the counter-factual as an illustration of this point?what if the Fed had not cut interest rates? Valuation risk would have stayed the same, but tighter monetary policy would have resulted in higher macroeconomic risk. The downturn would have restrained consumer spending and business investment to lower levels than currently prevailing, which would have led to a higher uncertainty about asset pricing. The financial accelerator mechanism would have then kicked in, with credit spreads increasing and economic activity contracting further. The result would have been a higher ?risk free rate? (on securities) and even higher interest rates for households and firms.
Mishkin therefore argues that monetary policy easing during periods of financial instability is an extremely important policy response. A natural criticism to this argument is of course the impact of this loosening of policy on inflation?after all, inflation-management is one of the key mandates of a central bank. Mishkin believes that the potential danger of ?unanchoring? inflation expectations that arise from loosening monetary policy to counteract macroeconomic risk is a direct function of the credibility of the central bank. If the bank maintains a record of credibility with the markets, then this danger can easily be minimised.
The author is consultant, NIPFP. These are her personal views