NCPA - National Center for Policy Analysis


December 30, 2008

The Federal Reserve's recent lowering of interest rates was welcome, but it was also received with skepticism.  Once the federal-funds rate is reduced to zero, or near zero, doesn't that mean that monetary policy has gone as far as it can go?  Such a view was used to rationalize the passivity of the Fed in the 1930s and the Bank of Japan in the 1990s.

But in both cases, constructive monetary policies were available but remained unused.  Fed Chairman Ben Bernanke's statement made it clear that he does not share this view and intends to continue to take actions to stimulate spending.

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.  This action has been the boldest exercise of the Fed's lender-of-last-resort function in the history of the Federal Reserve System.

How will this 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.
  • Adding directly to reserves -- the ultimate liquid, safe asset -- adds to supply of "quality" and relieves the perceived need to reduce spending.

There are many ways to stimulate spending, but monetary policy as Mr. Bernanke implements it has been the most helpful counter-recession action taken to date.  It entails no new government enterprises, no government equity positions in private businesses, no price fixing or other controls on the operation of individual businesses, and no government role in the allocation of capital across different activities.

Source: Robert E. Lucas, Jr.  "Bernanke Is the Best Stimulus Right Now," Wall Street Journal, December 23, 2008.

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