Sunday, October 21, 2007

Bernanke Say They'll Cut Aggressively, If...

Ben Bernanke gave a speech today covering academic developments in the area of Monetary Policy under Uncertainty. He didn't explicitly discuss current monetary policy issues, but he did give us a big clue when he talked about how economists' thinking about the structure of the economy has changed over the last 40 years: his elegant 1967 paper, Bill Brainard showed that uncertainty about the effect of policy on the economy may imply that policy should respond more cautiously to shocks than would be the case if this uncertainty did not exist. Brainard's analysis has often been cited as providing a theoretical basis for the gradual adjustment of policy rates of most central banks. Alan Blinder has written that the Brainard result was "never far from my mind when I occupied the Vice Chairman's office at the Federal Reserve. In my view, . . . a little stodginess at the central bank is entirely appropriate"
This has created the expectation in the markets that the Fed will adjust monetary policy gradually. Bernanke seems to want to dispel this belief:
An important practical implication of all this recent literature [on optimal and robust control] is that Brainard's attenuation principle may not always hold. For example, when the degree of structural inertia in the inflation process is uncertain, the optimal Bayesian policy tends to involve a more pronounced response to shocks than would be the case in the absence of uncertainty. The concern about worst-case scenarios emphasized by the robust-control approach may likewise lead to amplification rather than attenuation in the response of the optimal policy to shocks. Indeed, intuition suggests that stronger action by the central bank may be warranted to prevent particularly costly outcomes.
In introducing these topics, Bernanke made an explicit parenthetical reference to research on the "transmission mechanism of monetary policy." He gave an entire speech on the topic seven weeks ago, so that fact that he's bringing it up again should tell us how much he's thinking about it. This passage, from his Jackson Hole speech on Housing, Housing Finance, and Monetary Policy on Aug 31, 2007, summarizes that thinking:
The dramatic changes in mortgage finance that I have described appear to have significantly affected the role of housing in the monetary transmission mechanism. Importantly, ...housing is no longer so central to monetary transmission as it was. In particular, ...the availability of mortgage credit today is generally less dependent on conditions in short-term money markets, where the central bank operates most directly.... Most estimates suggest that, because of the reduced sensitivity of housing to short-term interest rates, the response of the economy to a given change in the federal funds rate is modestly smaller and more balanced across sectors than in the past.
So if we apply those messages to the current economic situation, what I'm hearing Bernanke say is:
  1. Monetary policy can't stop the current housing recession,
  2. Interest rate cuts will be slower and less effective that they used to be,
  3. So if we see the housing recession spillover into the broader economy, we will cut rates very aggressively.
With this in mind, your homework is to re-read the Beige Book, then go look at the Fed Funds probabilities for the Oct 31st meeting outcome. Then decide whether you agree with the market's assessment that no rate cut is more likely than a 50 bp cut (putting aside the fact that a 25 bp cut is most likely).

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