Ineffective Monetary Policy

August 26, 2008

Monetary policy in the modern age dictates that a central bank should provide liquidity and expand credit during a slowdown or financial crisis. But this time there’s every sign that isolated strong action by a single central bank is not only ineffective, but also counterproductive.

Of the major central banks of the world, only the Federal Reserve responded to the financial crisis with aggressive rate reductions. The ECB has chosen to interprete its legal mandate strictly, and has actually increased rates in response to inflation that has recently reached 4 percent. Rising inflation and rapidly deteriorating economic outlook has prevented Bank of England from acting decisively, while Bank of Japan has chosen to remain neutral but fearful, with rates already near zero. Brazil, Turkey, Thailand, China, Russia, India all face significant inflationary pressures, and some have been forced to raise rates in order to combat the risk of runaway inflation, which so far seems to have materialised only in Vietnam.

In the US and to a lesser extent in the EU, credit growth decelerated sharply, with banks and financial institutions tightening some forms of credit to unprecendented levels; in contrast, in most emerging markets money supply has continued to expand strongly, invigorated by flows of short term money from the industrialised world seeking better yield. Exacerbated by the parabolic rise in commodity prices, mostly a result of the falling dollar, the already heated economies of these developing nations have been grappling with increasing inflationary issues ever since the Federal Reserve began its rate cut cycle in September of last year.

The argument that rate reductions by the FED have prevented the situation from worsening in the US is devalued by the fact that in the Eurosystem the experience of financial institutions has not been any better or worse than those in the US. European banks have had massive exposure to problematic US paper, and some of the worst write-downs have been taken by a Swiss institution.

What is more, because of the lagged effect of constricted credit channels, the stimulative effect of reduced rates on the real sectors of the economy have been hardly felt so far. A shutdown of credit sources to non-financial institutions is far from being the case, both in Europe and the US, and central bank interventions have not prevented banks from shrinking balance sheets and squeezing credit where they believed it to be be necessary.

What then, has been the achievement of monetary policy thus far?

In the US, the result has been the falling dollar, and high inflation. Neither the fear premium on LIBOR, nor  mortgage rates have been ameliorated by lower rates. And the near failure of Bear Sterns occurred at a time when the Federal Reserve had already reduced rates by about 200 basis points from their August 2007 levels. Reduced rates, and even the new and innovative liquidity facilities announced by central banks, have not been successful in preventing financial participants from nervously speculating on who is to fall next.

In the rest of the world, where stimulus wasn’t needed, the Fed’s inflation gift, via the lower dollar, has forced central banks to increase rates, making sure that the only parts of the world where growth was relatively unhurt by the financial crisis would now be on the inevitable path to recession because of high interest rates necessitated by inflationary pressures.

The impact of the Fed cuts on the global economy has been mostly negative. The global recession that’s yet to be experienced in its full force is likely to be long lasting and painful.

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One Response to “Ineffective Monetary Policy”

  1. sandrar said

    Hi! I was surfing and found your blog post… nice! I love your blog. 🙂 Cheers! Sandra. R.

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