The role of monetary policy in the face of crises.

• Author: Schwartz, Anna J.

In this article I first review the Greenspan Fed's record of providing liquidity in response to its perception of shocks the economy is facing. It assumed that the shocks were likely to generate financial crises. No financial crises, however, have occurred. Yet the Fed was dilatory in draining the market of unneeded liquidity. Failure to do so meant that monetary policy remained accommodative.

I next discuss whether there is a connection between the Fed's accommodative policy and the depreciation since 2002 of the exchange value of the dollar as well as the twin deficits and growing global imbalances. In that discussion I refer to the need to raise the national saving rate, in part by eliminating the budget deficit as well as projected deficits from the unfunded liabilities of Social Security and Medicare. Monetary policy, however, must be independent of fiscal policy.

I conclude with some observations on the advisability of adoption by the Fed of inflation targeting.

The Accommodative Fed

Note the difference in the Fed's behavior in 2000 compared with the way it performed from 2001 to 2005. Because of apprehensions that the 2000 millennium would create widespread computer problems, the Fed undertook to provide a massive infusion of reserves into the monetary system. The year ended without incident. At the start of 2000, the Fed promptly withdrew the additional reserves.

In 2001, the Fed perceived that the economy would sustain shocks that it was prudent for it to counter with low interest rates. Among the shocks it observed were the recession that began in March, then the terrorist attacks in September, corporate accounting scandals, low employment growth in the initial months of the recovery, hikes in the price of gasoline, and in each case, the financial crisis the Fed feared would ensue did not eventuate. Yet the Fed kept the Fed funds target rate unchanged at i percent from July 2003 to June 2004, unjustified in view of the economy's growth rate, and then only slowly raised the rate 25 basis points each month until it paused at 5.25 percent in August 2006.

Among the consequences of the policy of maintaining interest rates at an inappropriate low level were credit and mortgage market distortions, discouragement of personal savings, incipient inflation, and deprecation of the dollar foreign exchange rate.

Are There Links between Fed Policy and Indicators of Global Imbalances?

In the quarter of a century between 1980 and 2006, in only three years was the U.S. current account in surplus and the capital account in deficit. (1) In every other year the current account was in deficit, that is, the United States imported more goods and services than it exported. The deficit in the past was small, $1 billion or $2 billion. Currently, the deficit is about $800 billion. Matching the current account deficit is the capital account surplus, that is, foreign investors financed the current account deficit by purchasing U.S. assets in excess of the purchases by U.S. investors of foreign assets.

The U.S. domestic saving rate is low. Perhaps the Fed's recent low interest rate policy has contributed to this trend, but there are surely other forces. One is that increasing individual wealth raises consumption at the expense of saving. A recent discussion paper by economists at the Minneapolis Fed and New York University proposes that the fall in U.S. cyclical volatility, greater than that experienced by its partners, reduces incentives to do precautionary saving, and can account for 20 percent of the U.S. external imbalance (Figli and Perri 2006). While personal saving has been declining, corporate saving has...