Visiting scholar R. Glenn Hubbard discusses the role of the Federal Reserve in the current credit crunch. He comments that, by keeping the federal funds rate low in order to combat liquidity concerns, the Federal Reserve has increased inflationary pressures in the U.S. economy.

Visiting Scholar  R. Glenn Hubbard

The combination of eye-popping headline inflation of 5% year over year and dramatic expansions of the Federal Reserve's lending activities to limit the credit crunch raise a key question: Are we asking too much of monetary policy?

The simple answer is yes. The expansion of the Fed's lending has been extraordinary in scale and scope. But it is not the best response to the present credit crunch, and may bring unwelcome side effects.

To assess the Fed's role as firefighter in the current financial turmoil, it is useful to start with the roots of the problem. Shocks to financial institutions' net worth affected the supply of credit from those institutions. Such credit restrictions reduced consumption and investment--otherwise known as a "credit crunch." The Fed's interventions have, of course, aimed at liquidity--the ability to fund increases in assets and meet obligations as they become due.

Recent events have highlighted the potential for market disruptions when banks are unable to provide liquidity--as in the case of structured investment vehicles and asset-backed commercial-paper conduits. The Fed has tried to limit downward asset price spirals by providing credit to lessen the need for fire sales in a scramble for liquidity.

The Fed's rush of liquidity injections reflect Walter Bagehot's classic "Lombard Street" advice "to lend freely." And its provisions of liquidity have been extraordinary--through a more attractive regular primary credit program, the Term Auction Facility, the Term Securities Lending Facility, the Primary Dealer Credit Facility, and now perhaps lending to Fannie Mae and Freddie Mac. One might ask, however, whether the successive liquidity injections at the onset of difficulty (as in the stock-market crash of 1987, the Long-Term Capital Management crisis of 1998, and the 9/11 attacks of 2001) have made market participants worry less about liquidity risk.

Of course, the Fed should not ignore systemic risk just to limit moral hazard. But if liquidity intervention is inevitable, the central bank must be able to supervise and regulate the beneficiaries of its liquidity insurance. Otherwise, such insurance fans moral hazard by failing to discourage taking on still more liquidity risk (read: the most recent crisis). And making that insurance more available simply raises this concern (read: where we are now).

The events of the past three years highlight that risk misperceptions in a boom can lead to a scramble for liquidity if collateral values decline. Ascertaining this problem in real time will always be tough for regulators (even for the increased number of regulators the Treasury recently proposed).

Importantly, Bagehot's admonition goes on to say: "The time for economy and for accumulation is before. A good banker will have accumulated in ordinary times the reserve he is to make use of in extraordinary times." That is, regulation of capital adequacy could require more capital to support incremental risk-taking in a boom, and lower such capital in a bust. With such requirements, financial institutions would find risk-taking marginally more costly in a credit boom, in which credit risk and liquidity risk are very low. In a downturn, a scramble for liquidity to meet capital requirements would be attenuated.

While strong supervision obviously remains important, this other advice from Bagehot would be an important addition to the policy tool kit. This could be implemented by raising banks' capital requirements proportionately as risk-weighted bank assets grow. By varying capital cushions over credit cycles, consequences of risk distortions for actual lending and borrowing decisions will be reduced, along with the likelihood of asset fire sales and extraordinary central bank liquidity provisions.

Remembering Bagehot's advice would give the central bank a way to deal with bank-lending bubbles. While a central bank's tools may be poorly suited to prick bubbles like that of the information technology boom of the late 1990s, a bank lending bubble can--and should--be addressed.

As with its new arrangements to augment liquidity, the Fed has aggressively reduced the federal-funds rate, with especially bold action in the past few months. The lower funds rate may augment collateral values, a key issue in the present crisis. But while this action may reduce credit stresses and downward pressure on asset prices, it is decidedly not in line with the Fed's stated long-run inflation objective of 1% to 2%.

We have been down this road before. In the aftermath of the 2001 recession, the Fed maintained the federal-funds rate below the rate of inflation even after the pickup in aggregate demand following the 2003 tax cut and the economy's recovery. The failure to normalize rates in a more timely way contributed both to house-price appreciation and to inflationary pressures. By contrast, the Fed's policy normalization in the mid-1990s built the Fed's inflation-fighting credibility without damaging the continued recovery from the 1990-1991 recession.

The current policy stance of holding the federal funds rate at 2% will keep monetary stimulus in place. With inflationary expectations not declining, this stimulus will almost surely raise inflationary expectations as the economy improves. This consequence can be seen already in surging commodity prices and the weakness in the foreign-exchange value of the dollar.

It is worrisome that the Fed's own 2008 projections have risen over the year both for headline inflation (by about 1.5 percentage points) and core inflation (by about 0.2 percentage points). Furthermore, the Fed's projections of receding inflation in 2009 and 2010 coming true will almost surely require increases in the federal funds rate.

A continuation of a negative real federal funds rate and the increase in money growth accompanying it raises the risk of increasing inflationary expectations, a costly mistake to fix.

It is asking a lot for monetary policy alone to carry the burden of supporting aggregate demand. Fiscal policy can play a role. Congress and President Bush did pass an economic stimulus package centered on tax rebates. But clarity about a positive future for the 2001 and 2003 tax cuts which bolster collateral values--along with a cut in corporate tax rates to promote investment--would offer a much more potent tonic.

While the Fed's heeding of Bagehot's "lend freely" advice has been in some ways helpful, central bankers may also want to note the limits contained in his earlier comment in "Physics and Politics" that "[a]n inability to stay quiet . . . is one of the most conspicuous failings of mankind."

R. Glenn Hubbard is a visiting scholar at AEI.