Friday, December 19, 2008

The Federal Reserve’s New Target Range

On December 16, 2008, one of the most significant monetary policy decisions in US history was handed down by the Federal Reserve's Open Market Committee (FOMC). In an effort to combat accelerating deflation in the Consumer Price Index (CPI) and massive job losses, the FOMC announced a reduction of its federal funds rate target from 1% to an unprecedented range of 0% to 0.25%. While critics of the move might point to relatively stable core inflation rates (which exclude food and energy), the FOMC was clearly more concerned about the state of the job market and the accelerating deflation reflected in the headline CPI. In fact, for two consecutive months, the US experienced record CPI deflation with rates of -1% in October and -1.7% in November of 2008. Along with OPEC's attempts to curtail oil production, this move by the FOMC is likely to help stabilize the price level.

The Fed announcement is historic for the low level of rates in its targeting and for the unique setting of a target range. This gives the Fed modest room for flexibility above the nominal floor of a zero federal funds rate. Whether it will be enough to spur the feeble economy is doubtful. Fortunately, the FOMC also announced that the federal funds rate is likely to remain within the target range for an extended period. The central bank is also prepared to purchase agency debt and mortgage-backed securities. Furthermore, through the Fed's expanded toolkit, it will begin direct loans to households and small businesses starting in 2009.

Fed chairman Ben Bernanke recognizes that the US economy is ripe for implementing the tenets of his Bernanke Doctrine, outlined in his 2002 speech titled "Deflation: Making Sure 'It' Doesn't Happen Here." In that speech, well before he was appointed to chair the Fed, he stated, "the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending—namely, recession, rising unemployment, and financial stress." Bernanke now has the chance to run the Fed during the precise scenario that he described six years ago.

In fact, the FOMC's press release of December 16, 2008 announces policy that effectively implements most of the seven steps of the Bernanke Doctrine. The FOMC's bold move may stave off a severe recession, but it does not come without potential costs. The combination of aggressive monetary policy, and recent and proposed fiscal stimulus could eventually reduce confidence in the US Treasury's ability to service its debts.

For the time being, Chairman Bernanke appears to be doing what is necessary to support another of his statements from six years ago:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve System. I would like to say to Milton and Anna [Friedman]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

Discussion Questions

1. What could be the negative ramifications of implementing such a bold expansionary monetary policy at this time? How likely do you think it is that such negative ramifications occur?

2. Do you believe that historically low interest rates will be sufficient to save businesses struggling to avoid bankruptcy, such as those in the auto industry?

3. The current state of the US economy bears remarkable similarity to that of the beginning of the Great Depression. Do you think that Chairman Bernanke and his doctrine will keep the US out of a deflationary spiral? Will the doctrine, along with fiscal policy from recently elected officials, be enough to keep America out of a depression?

4. The US national debt held by the public is currently about $6.4 trillion or 45% of the nominal GDP in 2008. Is there any reason to worry over the ability of the US Treasury to meet national debt obligations? Why or why not?

5. Now that gasoline prices have returned to low levels, some economists may believe that it is an appropriate time to raise the federal gasoline tax. Do you agree with this position? Why or why not?

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Friday, December 12, 2008

Should the Government Bail Out the Auto Industry?

America's Big Three—General Motors, Chrysler, and Ford—are in big trouble. Sales from the not-so-fuel-efficient fleet of American-made vehicles had already suffered considerably because of high gas prices even before the financial crisis began to get serious in September of 2008. Faced with undesirable terms in private credit markets, the Big Three are now turning to the government for financial assistance. The House passed a bill to rescue the Big Three car companies with $15 billion in emergency loans on Wednesday, December 10, but the Senate abandoned the plan the day after. Should the government bail out the auto industry?

Those in favor of the bill argued that the rescue plan can prevent the loss of 500,000 jobs in the auto industry. Job losses in the auto sector would most likely have spillover effects in other sectors. As auto workers lose their jobs, they would consume fewer goods and services, negatively affecting industries in retail, health care, and financial services. With unemployment already rising, supporters of the bailout argued that keeping auto workers in their jobs is much easier than creating new jobs for them.

Opponents of the bill compared the bailout to the inefficiencies generated by government subsidies and tariffs. Many companies face financial problems—why should the government save the Big Three and not the others? Poor performance is typically a good signal that a company should change how and what it produces. A partial government takeover of American auto companies will not ensure that the firms will start producing vehicles that people want to buy. A bailout, according to critics, will simply prolong the inevitable: the consolidation of the American auto industry, the large number of layoffs that come with it, and the migration of workers from autos to more profitable industries.

Discussion Questions

1. What is the role of labor unions in contributing to the financial problems facing the Big Three? In particular, how well do the wages reflect the productivity of the workers in the Big Three? Click here to read more.

2. Do you think the problems faced by the Big Three stem primarily from the recent financial crisis or from longer-term decisions about what types of vehicles to produce and how to produce them?

3. Some suggest that another reason leading to the failure of the Big Three is that American consumers prefer cars made by foreign companies, such as Toyota and Honda, to cars made by American-owned companies. How does the market of foreign-made cars affect the demand for American cars?

4. Foreign-owned automakers, like Toyota and Honda, operate production facilities in the United States and employ American workers. How would these firms be affected by a bailout of the American-owned Big Three? How will foreign auto firms with operations in and outside of the United States be affected if one or more members of the Big Three were allowed to fail?

5. How do the loans compare with tariffs in foreign trade? What advantages and disadvantages do they share in common?

6. What would happen to the broader economy if the plants closed and workers became laid off? What might these workers do to find new employment? Which sectors would employ them?

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