On Monday, the Federal Reserve’s Board of Governors took the dramatic move of lowering the federal funds rate—the interest rate the Fed charges banks on short term loans—by 50 basis points. A half point cut would normally be noteworthy by itself. But this cut was particularly newsworthy because it lowered the federal funds rate to 0.25 percent—one quarter of one percent—its lowest rate ever.
The Fed hopes that the move will provide the market a clear signal of the Fed’s willingness to take sweeping action to address the current financial crisis. And indeed, U.S. markets briefly reacted positively to the announcement, with equities increasingly slightly before falling by day’s end.
However, the move also raises some concerns. First, with the U.S. funds rate so much lower than the rate of other major central banks (especially in European Union), the move may put downward pressure on the dollar. This could help the U.S.’s balance of trade, but it may also make investors more hesitant to hold dollar-denominated assets, particularly U.S. Treasury Bills, due to their historically low yields. Some groups within the Chinese government, the single-largest holder of U.S. t-bills, have already raised such concerns and have been pushing the Chinese government to diversify its holdings. Were this to happen, the U.S. government could find it increasingly difficult to finance its operations, not to mention its $10 trillion debt.
More generally, however, the current low federal funds rate raises some important questions regarding the relative influence of (Neo)Keynesian and Monetarist policy in the United States. Since the early 1980s, monetarism has been the prime approach to managing the nation’s economy, and the most important tool in the monetarist policy kit is arguably the federal funds rate. By increasing the rate, the Fed can slow down the economy and bring inflation under control. Conversely, by lowering the rate, the Fed can inject liquidity into the system, stimulating the economy and encouraging expansion. Until recently, this system worked relatively well, keeping recessions (such as the one that occurred in 1990-1991) relatively short and shallow.
But with the federal funds rate now near zero percent (and potentially negative in real terms), the most important tool in the monetarist economic policy kit is no longer available. If this move does not work—and there is good reason to think that it may not—the Fed will be forced to come up with new ways to stimulate the economy.
The current situation may therefore call for a return to Keynesian policies of this post-Great Depression era. By focusing on the maintenance and expansion of aggregate demand, Keynesian policies may provide an additional tool for the U.S. government to address the current crisis. Although Keynesianism may have fallen out of favor in the 1980s, in truth Keynesian policies never fully disappeared from the scene. Since the 1980s, the U.S. government has been much less willing to use Keynesian tools than it historically had been. But now that monetarism’s most important tool has been exhausted, perhaps we are all, to paraphrase Richard Nixon, Keynesians again.
If you’re interested in learning more, Paul Krugman has written extensively on the topic. There’s a great ongoing discussion of his book, Return of Depression Economics, at Taking Points Memo. And Krugman’s blog always makes for an interesting read!