One of the most puzzling aspects of the economy today is the
apparent impotency of monetary policy. The Federal Reserve has been lowering
interest rates and increasing the money supply at a healthy clip for almost
2 years. Under normal circumstances, economists would have expected this
added liquidity to significantly stimulate growth by now. Yet there is no
evidence that this is the case.
Increases in the money supply stimulate growth by putting upward
pressure on prices. Higher prices for goods and services raise corporate
profits, leading to increased investment and employment. Carried too far,
the result is inflation. But at present, the economy's fundamental problem
appears to be deflation -- falling prices -- not inflation.
Deflation has the opposite effect of inflation. When companies
cannot raise prices, but instead must continually cut them, profits
evaporate. This causes stock prices to fall, which reduces net worth.
Eventually, consumers cut back on spending and banks restrict lending as
credit quality deteriorates. This results because stocks are often used as
collateral for loans. When stocks fall, therefore, it forces banks to call
in loans and raise interest rates.
As Brookings Institution economist Barry Bosworth explains in
the Milken Institute Review, "Deflation in a depressed economy accentuates
the decline in economic activity by punishing borrowers and threatening the
solvency of banks; this in turn restricts their lending."
In a recent column, I noted that total commercial and industrial
loans are down by $113 billion since the beginning of the recession last
year. On Sept. 20, the Federal Reserve released new data on business lending
by banks. They show the spread or difference between the federal funds
interest rate and interest rates charged to businesses has increased from
1.56 percent in 1996 to 2.17 percent now.
This is important because an increase in the spread is an
indication of declining credit quality. As more business loans go bad, banks
must charge more to cover their losses. They also tighten standards for
lending, thus making credit less available. The impact is worst for small-
and medium-sized businesses, which are the sparkplugs for employment growth
in our economy. Big corporations normally don't need to borrow from banks
because they can raise all the money they need in the commercial paper
An increase in the interest rate spread also means that monetary
policy is not as stimulative as it appears. Banks obtain their funds at the
federal funds interest rate, which has been set by the Federal Reserve at
1.75 percent. But if credit quality is falling, then increases in the money
supply are bottled up in the banking system, rather than being dispersed
throughout the economy. In other words, monetary policy is short-circuited
and becomes ineffective for stimulus.
This explains why the economy is still showing signs of
deflation despite record low interest rates and relatively high money
growth. Although many economists continue to deny the existence of
deflation -- putting their faith in the money supply to eventually become
inflationary -- they are dwindling in number. For example, in a Sept. 22
report, economist Ed Yardeni of Prudential Financial says deflation "is no
longer a theoretical risk."
Yardeni points out that the broadest measure of the price
level -- the price deflator for gross domestic product -- was up 1 percent
in the second quarter over the previous year. But the deflator was down 0.6
percent for non-financial corporations. This is the first time the two
figures have diverged from each other since they started being collected in
1958. This deflationary pressure, Yardeni believes, is the principal cause
of low earnings, which is holding down stock prices and capital spending.
Although the Federal Reserve has yet to acknowledge the
existence of deflation, it is clearly giving thought to the possibility. An
internal Fed study in June looked at the problem of deflation in Japan,
where interest rates have fallen close to zero without stimulating growth.
The study concluded that deflation undermines the effectiveness of monetary
policy, making it harder for central banks to stimulate growth
Bush administration officials continue to talk about putting
forward some new tax initiatives to jumpstart growth and investment.
However, if the problem is a credit crunch that is short-circuiting monetary
policy, then tax cuts may be ineffective. The administration needs to look
into this possibility and see whether federal policies can reverse it.