Wednesday, June 17, 2009

What Monetary Policy Cannot Do

Copyright, The New York Times Company

Six months ago, the Federal Reserve chairman, Ben S. Bernanke, announced that he might widen the scope of monetary policy by purchasing long-term Treasury securities. Market commentators had high expectations for the results of Mr. Bernanke’s new actions, but the results so far have been what Milton Friedman anticipated: disappointing in terms of both interest rates and inflation.

More than 40 years ago Mr. Friedman said in his famous address to the American Economic Association that “we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve” (American Economic Review, March 1968, p. 5).

Perhaps because Mr. Friedman’s warning was 40 years old, or because it was offered during “normal” times, or because the financial crisis rekindled the fantasy that our government can control the economy, Mr. Friedman’s warning was ignored last December. Mr. Bernanke said his approach would help “spur aggregate demand.” Market commentators went further and said that long-term rates would fall, and that this would help people buy homes and help businesses make investments.

Milton Friedman warned “The initial impact … is to make interest rates lower for a time … after a somewhat longer interval, say, a year or two, [this would] return interest rates to the level they would otherwise have had.” (p. 6, emphasis in the original). Was Milton Friedman right? Or did Mr. Bernanke’s shift stimulate the housing market?

The chart below graphs the yield on 10-year Treasuries for the days of 2008 and 2009, together with a vertical line indicating the day of Mr. Bernanke’s announcement. It suggests that Mr. Friedman’s warning — considered somewhat radical at the time — was actually too modest for today. Yes, Treasury yields did drop the day Mr. Bernanke made the announcement and later that month reached a low of almost 2 percent. But yields closed at almost 3 percent — higher than when Mr. Bernanke made his announcement — only 67 days later.

By now, long-term Treasuries yield 3.5 percent to 4 percent — typical of the range of yields during most of last year, before Mr. Bernanke made the policy change.

If monetary policy cannot have much of an effect on long-term interest rates — the rates that drive housing and capital markets — what can it do? It might try to maintain a steady rate of inflation, but Mr. Friedman said even that might prove too difficult because of the weak short-run links between monetary policy and inflation. Mr. Friedman seems to have been correct about that, too, because prices have fallen much as they did in 1929-30, despite the differences in monetary policy.

Milton Friedman was right that “it would constitute a major improvement if the monetary authority followed the self-denying ordinance of avoiding wide swings.” (p. 16) He certainly was right about the consequences of doing otherwise.


Boomer said...

As hard as it is for people to learn the lesson - there is no free lunch. If the Obama administration wanted to make a financial reform with lasting impact, it would reform the Fed. A good start would be to eliminate their dual mandate and have them concentrate solely on maintaining the purchasing power of the dollar. That's the only thing they can affect in the long run.

Anonymous said...

so much for fine tuning?