August 22, 2008 / 4:47 PM / 11 years ago

Economists see close Fed rate policy, stability tie

JACKSON HOLE, Wyoming (Reuters) - Separating the Federal Reserve’s interest rate moves from those aimed at boosting financial stability is not the best way to support the U.S. economy, according to two leading economists.

In a paper due to be presented on Friday at the Kansas City Fed’s annual economic forum, economists Tobias Adrian and Hyun Song Shin argued that the Fed’s actions on short-term rates and on financial stability are “two sides of the same coin.”

Monetary policy that anticipates a potential disorderly unwinding of leverage, or shrinking of positions, by financial firms in the event of a credit market crisis could better help prevent a drop in real economic activity, the two argued.

Adrian is a capital markets economist at the New York Fed; Shin is an economics professor at Princeton University.

The paper focused on the theme of this year’s Jackson Hole econo-palooza — picking up the pieces from the year-long credit crisis that has frozen capital markets and plunged the United States economy to the brink of recession.

Some Fed officials have argued that the central bank’s primary policy tool, the federal funds rate, is best left as a lever to address the issues of inflation and growth, the Fed’s traditional policy mandates.

In a speech last week, Chicago Fed President Charles Evans said the Fed’s raft of liquidity tools aimed at easing strains in credit markets “allow our policy actions with regard to the fed funds rate to focus on broader macroeconomic goals.”

But Adrian and Shin argued that short-term rates are a more important instrument than acknowledged by some policy-makers, who see the rates mostly in terms of their implications for long-term rates and, thus, inflation expectations.

“To the extent that financial intermediaries play a role in monetary policy transmission through credit supply, short-term interest rates matter directly for monetary policy,” they said.

In particular, the economists said the ebb and flow of balance sheets among broker-dealer firms give a sense of how well changes in monetary policy are being transmitted to the broader economy.

“Experience has shown time and again that the most potent tool in relieving aggregate financing constraints is a lower target rate,” they said.

“In conducting monetary policy, the potential for financial sector distress should be explicitly taken into account in a forward looking manner.”

Writing by Ros Krasny in Chicago, Editing by Chizu Nomiyama

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