The discussion resurfaced, or picked up pace, as the Federal Funds rate only reached a range of 2.25-2.50 % before being cut again, by a quarter point, on the last day of July. Before the financial crisis, the target rate was 5.25 %, allowing space for major cuts. The latest cut indicates that such levels are no longer attainable.
Has monetary policy painted itself into a corner?
This is not the place for predictions, but a wider, historical sweep may be in order. As for economic policy intended to influence growth, there are two major levers: fiscal policy (government budgets) and monetary policy. Pulling hard on policy levers is nothing new: Up until the financial crisis the former was pretty much maxed out in most Western countries (with a notable exception for countries with oil revenues).
From 1974 to 2007, US federal debt rose from below 32 to 64 per cent of GDP, according to professor Carmen Reinhart – and that's a GDP that increased by a factor of almost twelve. In real terms, GDP tripled, fuelled by the very government spending and tax cuts that this debt financing made possible.
Other Western countries were even more eager to spend.
In Germany government debt rose from 18 to 65 per cent of GDP, while Sweden saw its debt rise from 27 to 73 per cent as early as 1996 – when they actually hit the brakes, as another notable exception. In general, fiscal policy was not really oriented towards smoothing out cycles; in a longer perspective, it was used to pump up the economy (with a little less force when growth was good).
While textbooks regard such stimulus as temporary, they do not envision a prolonged period of accumulated stimulus. An impulse of this magnitude surely induces major change, bringing about increased investment, pushing the technological frontier, upgrading labour market qualifications etc. – and making us overrate endogenous productivity growth.
With the financial crisis, however, it became obvious that fiscal policy was more or less exhausted.
With the cost of additional debt outweighing the stimulative benefits. And so the emphasis shifted to monetary policy. In the absence of fiscal leeway, monetary policy must do the job.
The fiscal era taught us that hitting the gas is far more pleasurable than hitting the brake (and I dare say a couple of recent tweets have reinforced that perception).
Is there anything to suggest that this time is different?
Finn Øystein Bergh
Chief Economist & Strategist
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