Monetary and Fiscal Policies Following Crisis Management

Monetary and Fiscal Policies Following Crisis Management In Fall 2008, financial markets convulsed with shock, and the recession deepened abruptly and quickly spread globally. Monetary and fiscal policies, already aggressively addressing the recession and financial strains, shifted into crisis mode, and an unprecedented set of crisis management policies were quickly implemented. Since that time, financial markets have stabilized and the economy has adjusted, benefiting primarily from the Federal Reserve's extraordinary liquidity provisions. The recession has ended, and economic recovery has begun. Policymakers must now put into motion strategies that will unwind their crisis management and re-establish sustainable policies, consistent with long-run macroeconomic objectives. So far, the Fed has acknowledged that it must exit from currently unsustainable monetary policies and raise interest rates. Its lack of full transparency stems from its own uncertainty regarding strategic details and timing. But the Fed knows its ultimate objectives: to withdraw excess liquidity, shrink its bloated balance sheet and raise interest rates consistent with the Fed's dual mandate of low inflation and unemployment. In contrast, fiscal policymakers—the Administration and Congress—have shown no indication that any adjustments to the current thrust of fiscal policy are needed. Certainly, current fiscal policymakers cannot be blamed for the mounting unfunded liabilities of the entitlement programs. But new, large deficit spending initiatives defy the widely held assessment that the current thrust of policy is unsustainable and damaging to longer-run economic performance. Long-run fiscal strategies, based on sound analysis and transparency, and untainted by short-run political considerations, are needed to re-establish realistic and credible policies. The Fed's Agenda The rapid runoff of short-term securities from the Fed's balance sheet and the dramatic narrowing in Libor spreads confirm the success of the Fed's post-Lehman crisis management and financial stabilization. The Fed's open market purchases of mortgages have lowered mortgage rates, helping to support demand for housing and generate a surge in mortgage refinancing that has improved household balance sheets. However, the Fed's quantitative easing has dramatically expanded reserves and the monetary base, lengthened the duration of the Fed's balance sheet and entwined the Fed in credit allocation. The Fed must set out an exit strategy, including ending its participation in other crisis management policies, most notably the PPIP. Even if the dramatic build up in the monetary base does not result in higher inflation in the near term—and I do not believe it will, as wage and price pressures are likely to be temporarily constrained by weak aggregate demand and slack in the economy—the Fed's policies involve other costs. The US dollar is falling, reflecting lower real expected rates of return on US capital, which lowers standards of living. And the Fed's involvement in the credit allocation process is a highly undesirable activity under normal conditions. The Fed's exit strategy should involve several aspects. The Fed should announce that its purchases of US Treasury securities will not be renewed or extended. They no longer serve any purpose and only add to excess reserves. The Fed should announce its intention to reduce the size of its mortgage purchase program. Any resulting back up in mortgage rates would be moderate and would not sidetrack the rebound in housing. Home prices are stabilizing and liquidity has returned to the mortgage market; extending the Fed's purchases increases the difficulty of the Fed's exit and eventually would drive bond yields even higher,download.