The Federal Reserve’s lowering of interest rates last Tuesday was welcome, but it was also received with scepticism. Once the federal funds rate is reduced to zero, or near zero, doesn’t this mean that monetary policy has gone as far as it can go? Fed chairman Ben Bernanke’s statement last Tuesday made it clear that he does not share this view and intends to continue to take actions to stimulate spending.
There should be no mystery about what he has in mind. Over the past four months, the Fed has put more than $600 billion of new reserves into the private sector, using them to discount—lend against—a wide variety of securities held by a variety of financial institutions.
Why do I describe this as an action to stimulate spending? Financial markets are in the grip of a “flight to quality”. Everyone wants to get into government-issued and government-insured assets, for reasons of both liquidity and safety. Individuals have tried to do this by selling other securities, but without an increase in the supply of “quality” securities, these attempts do nothing but drive down the prices of other assets. The only other action people can take as individuals is to build up their stock of cash and government-issued claims to cash by reducing spending. This reduction is a main factor in inducing or worsening the recession. Adding directly to reserves—the ultimate liquid, safe asset—adds to supply of “quality” and relieves the perceived need to reduce spending.
When the Fed wants to stimulate spending in normal times, it uses reserves to buy treasury bills in the federal funds market, reducing the funds’ rate. But as the rate nears zero, treasury bills become equivalent to cash, and such open-market operations have no more effect than trading a $20 bill for two $10s. There is no effect on the total supply of “quality” assets.
A dead end? No. The Fed can satisfy the demand for quality by using reserves—or “printing money”—to buy securities other than treasury bills. This is how the $600 billion got into the private sector.
This expansion of Fed lending has not violated the constraint that “the” interest rate cannot be less than zero, nor will it do so in the future. There are thousands of different interest rates out there and the yield differences among them have grown dramatically in recent months.
Could the $600 billion in new reserves be called a bailout? In a sense, yes: The Fed is lending on terms that private banks are not willing to offer. They are not searching for underpriced “bargains” on behalf of the public, nor is it their mission to do so. Their mission is to provide liquidity to the system by acting as lenders of last resort. We don’t care about the quality of the assets the Fed acquires in doing this. We care about the quantity of its liabilities.
There are many ways to stimulate spending, and many of these methods are now under serious consideration. How could it be otherwise? But monetary policy as Bernanke implements it has been the most helpful counter-recession action taken to date, in my opinion, and it will continue to have many advantages in future months. It is fast and flexible. There is no other way that so much cash could have been put into the system as fast as this $600 billion was, and if necessary it can be taken out just as quickly. The cash comes in the form of loans. It entails no new government enterprises, no government equity positions in private enterprises, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities. These are important virtues.
The Wall Street Journal
Edited excerpts. Robert E. Lucas Jr is a professor of economics at the University of Chicago and winner of the Nobel Prize in economic sciences in 1995. Comment at email@example.com