March 29, 2002

The FOMC's January 29 Meeting

< "A meeting of the Federal Open Market Committee...January 29, 2002... if the economy were to deteriorate substantially... short-term interest rates... already... very low... unconventional policy measures... efficacy... uncertain... it might be impossible to ease monetary policy sufficiently through the usual interest rate process...." It was a decade ago that Larry Summers and I wrote that it would be unwise to work hard to push inflation below 4 percent or so precisely because of the danger that the economy might then wedge itself into the position that the Federal Reserve now fears.

Now it is important to note that the Federal Reserve is not contemplating any form of action. There is no clear and present danger. The minutes report that the Open Market Committee was discussing "... staff background analyses..."--contingency planning for possible future events that has bubbled up to and is found intellectually interesting by the members of the Open Market Committee.* The minutes say that this discussion was a sidetrack from the Open Market Committee's business at hand: "The members agreed that the potential for such an economic and policy scenario seemed highly remote..."

Nevertheless, the basic point is potentially very important, and I at least find it also very interesting. The Federal Reserve's conventional policy measures control a particular short-term interest rate--the interest rate on "Federal Funds", which are deposits in the twelve regional Federal Reserve Banks that commercial banks can use to satisfy the Federal Reserve-imposed reserve requirements. But the interest rate that matters in influencing business investment decisions is not the short-term, nominal, safe interest rate that is the Federal Funds rate, but the long-term, real, risky interest rates that businesses seeking to increase their capacity face when they try to borrow. The Federal Reserve seeks to keep the economy at full employment by changing interest rates in order to boost or retard business investment.

However, there is lots of slippage between the interest rate that the Federal Reserve usually controls and the one that is relevant for business:

First there is the gap between long-term and short-term interest rates. Long-term rates are usually but not always higher than short-term rates, and the gap depends on what people think future monetary policy is likely to be and is often stubbornly resistant to Federal Reserve action. If the Federal Reserve wants interest rates to be low, but if financial markets think that policy might change, it may take a very large reduction in short-term rates to carry long-term rates to the point the Federal Reserve wants. Second there is the gap between safe and risky interest rates. Everyone is sure that the U.S. government will repay its debts. But when you lend money to or buy a bond issued by a corporation, you are not sure. The risk and default premium drives another wedge between the interest rates the Federal Reserve typically controls and those that businesses have to pay. And this risk and default premium can also suddenly jump and remain stubbornly high. Here too, it might take a very large reduction in safe interest rates to carry risky interest rates to where the Federal Reserve wants them to be.

Last, there is the wedge between real and nominal interest rates. The Federal Reserve controls how many dollar bills you will have to repay at the end of a loan in order to borrow a dollar bill's worth of purchasing power today. But businesses care about real interest rates--how many units of your product you will have to sell in order to pay off the loan you took out to expand your capacity. If the nominal interest rate is 10% per year and the inflation rate is 10% per year, it is the same to you as a business as if the nominal interest rate were 0% and the inflation rate were 0%. In the first case you have to pay back more dollar bills to pay off your loan but, as long as the prices of your products rise with the average as inflation proceeds, the nominal number of dollar bills you can sell your products for grows fast enough to offset this.

Suppose, for example, that the Federal Reserve sets the Federal Funds rate at 3% per year, and that there is a term premium of 3%, a risk and default premium of 3%, and an inflation rate of 2%. Then the real interest rate that matters for business investment is 7%--3% plus 3% plus 3% minus 2%. Now suppose that the Federal Reserve staff appear, and say that their studies suggest that full employment requires a real interest rate of 3%. Then--with an inflation rate of 2%--the Federal Reserve is out of luck: It cannot drive the nominal interest rate on Federal Funds below zero, and so it cannot drive the real interest rate relevant for businesses below 4%--3% plus 3% minus 2%. Hence the Federal Reserve staff spends some of its time thinking about "unconventional policies": things it could do that might affect the term premium, and the risk and default premium. However, as the minutes noted, these policies have "...efficacy... uncertain."

Note that this potential problem would cast much less of a shadow on the future if inflation were a little bit higher. At an annual inflation rate of 5%, the Federal Reserve could push real interest rates down to 3% with normal, conventional interest rate policies: a nominal Federal Funds interest rate of 2% would produce a real interest rate of 3%--2% plus 3% plus 3% minus 5%.

Hence Larry's and my point a decade ago: if you think there is a good chance that maintaining full employment will require you to goose the economy substantially and push real business-relevant interest rates down to very low levels, then be wary of carrying the fight against inflation too far and pushing inflation too low. Either that, or figure out how to design unconventional policy measures that will be effective at unwedging the economy if the "zero bound," the fact that the Federal Funds rate cannot fall below zero, keeps the normal interest rate manipulation tools of the Federal Reserve from carrying the business-relevant interest rate to where it needs to be.

Posted by DeLong at March 29, 2002 10:05 PM | TrackBack

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