classical economics
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and policy design

Half-Measures Bad Policy
HALF-MEASURES
OF BAD MONETARY POLICY

By Wayne Jett
© December 13, 2007

    After tarrying through weeks of public outcry for decisive action to relieve financial strains inhibiting markets in commercial paper and other debt instruments, the Federal Reserve on December 11 announced a quarter-point reduction in the overnight funds rate and in the discount rate. Investors greeted that news with a mighty Bronx cheer, the Dow index of 30 industrials dropping more than 300 points from its level before the Fed “action.” By the end of the day, anonymous Fed sources leaked word the Fed had “other weapons” to be used in the days ahead. Rather than inducing new hope, the leak was greeted with rising impatience.
An Interim Work-Around
    Next morning, December 12, the Fed announced a Term Auction Facility (TAF) to “auction term funds to depository institutions against the wide variety of collateral that can be used to secure loans at the discount window.” In addition, the Fed announced the FOMC approved providing $20 billion to the European Central Bank and $4 billion to the Swiss National Bank for use in foreign exchange transactions. Is something seriously wrong with the currency when dollars must be furnished specially to foreign central banks?
    The Fed’s TAF will open a small arena within which markets will be allowed to influence the pricing of credit from the Fed. Banks will be permitted to bid for credit, and bids will surely be well below the Fed’s current overnight funds rate, which is 4.25% after the reduction of December 11. Assuming the Fed accepts market bids, perhaps banks will borrow funds for use in buying commercial paper and other debt instruments issued by business firms with good credit. This would be a good thing, as ongoing contraction in credit markets threatens a collapse in economic growth. Thankfully, the Fed noted this threat and moved to counter it.
A Limited Auction of Market Rates?!
    Defining the Fed actions simultaneously identifies both the source of the problem and the inadequacy of the actions taken. A special auction for Fed credit is necessary because the Fed’s own funds rate and discount rates are too high. The too-high funds rate prevents normal functioning of processes by which banks obtain funds at market rates and lend to others, also at market rates adequate to cover risk and profit. To solve the problem, the Fed should drop its funds rate (and discount rate) to a point on a normal yield curve (below market rates for short-term Treasury securities) or, much better yet, allow the market to set the overnight funds rate. Instead, the Fed proposes to conduct an auction of a limited amount of credit at a minimum bid rate. Categorically this is a half-measure inadequate to alleviate severe credit constrictions caused by the Fed funds rate itself.
    Continued attempts to make manipulation of domestic interest rates the central focus of U. S. economic policy are indefensible. The funds rate fails to control rates at any other point on the yield curve, thus producing the “financial strains” so prominent in the Fed’s current thinking. Worse, even while credit markets continued to function for larger firms during the past 18 months, high funds rates set by the Fed penalized small business and consumers, draining capital and destroying jobs. Throughout this period, the dollar suffered from a weakened economy and lower demand for liquidity. Both influences reduced the dollar’s value when liquidity was not drained. Thus, funds rate manipulation causes economic contraction, inflation or both.
Do Right and Reform Policy Now
    Public calls for the Fed to float the funds rate are growing louder. This week publisher and former presidential candidate Steve Forbes renewed his advice that markets should set the overnight funds rate. Arthur Laffer joined in that view. Two weeks ago, former Fed governor Wayne Angell recommended the Fed should proclaim its commitment to strengthen and stabilize the dollar by managing liquidity towards that end. Coupling these two actions – floating the funds rate and managing liquidity with a gold price target - would provide the complete remedy now lacking in Fed policy.
    What few understand is that a market-set funds rate is not synonymous with flooding the economy with additional liquidity. The funds rate is not the valve to liquidity flows that it has been represented to be. A floating funds rate allows normal yield curve and credit flows, which means economic growth would be released from its present restraints. But liquidity would still be controlled by the Fed’s open market operations, which ought to be guided by commitment to stabilize the dollar at a strengthened level.
    Fed chairman Ben S. Bernanke is mid-stride in performance that to date is uninspiring. He risks producing a collapsing dollar and serious recession during a presidential election year. Either would be bad for Americans, bad for global economies and bad for prospects of one who aspires to long tenure as Fed chairman.
    Alternatively, by following the Angell-Forbes-Laffer path of free market interest rates and an honest dollar, Bernanke can become the most significant and successful chairman in Fed history, not to mention the pre-eminent central banker in the world. He would deserve the accolades, because market-based monetary policy would leave Americans and the world plenty to celebrate all around. ~