The main method by which the Fed actually controls monetary policy is through repurchase agreements in the overnight lending market. The short term interest rates that get established through the federal funds rate then gets transmitted to the commercial paper and money markets that that has an immediate impact on the rate of business activity. Commercial bank interest rates really don’t have that huge of an impact on the rate of business activity and certainly not an immediate one. Most money flows in the United States go through the credit markets, with the commericial banks having somewhat of a passive role.
This is very different from how monetary policy works in China where there is no linkage between short term interest rates and commericial activities, and the method of controling the economy is through reserve requirements which impact how much the large banks can lend out to the big corporations. The current mechanism of trying to control the economy through reserve rates was developed late-2005/early-2006. The PBC raised interest rates. Nothing happened. They increased reserve requirements, things happened.
One consequence of this is that the Fed can control short term interest rates, but not long term interest rates, and between 2005-2006 the combination of the Fed trying to keep interest rates down combined with a war in Iraq resulted in a really, really steep yield curve, and this led to all sorts of silliness as people used short term borrowing to fund long term loans in things like real estate. The combination of near zero short term interest rates and 6% long term rates is what led to “teaser rates.”
However the game book has changed over the last month. One reason I think that both Paulson and Bernanke were alarmed at the short term credit markets freezing is that frozen short term credit markets means that the Fed and central banks no longer have any control over monetary policy, which is why the Fed and Treasury are basically forcing banks at gunpoint to lend. The fear is that you will end up with a situation in which you set interest rates at zero, and then nothing happens.
The result of this is that I think that the tools that the Fed will be using to manage monetary policy six months from now, may be very, very different than they were six weeks ago. The only thing that I do know is that the financial world in August 2009 will be very, very different than in August 2008. What the differences are, I do not know.
The thing about finance textbooks is that they often have information that is years out of date, and they give the very false impression that everything has been worked out. One thing that is fascinating about the current episode is that you are watching people literally rewriting the textbooks day by day. Part of the reason I’m in a harsh mood against the pundits is that a lot of things that happen in finance are people making things up as they go along and figuring things out by trial and error. There are things that we know now that we didn’t know in early September, and policy makers are going to certainly do things right now that we will know to be stupid in six months or even in six days. I wouldn’t be surprised if at the end of next week the Dow is at 10,000 or if it at 6.000. I wouldn’t be surprised if at the end of next week, it turns out that everything that was announced thus far seem to be working perfectly. I also wouldn’t be surprised if there is some crisis tomorrow that causes everything to fall apart and we’d be tossing Plan C, for Plans D, E, and F.
Given the difficulty of what is being done, and the stakes, I think it is just a little rude to be screaming at the supposed incompetence of the fire fighters as they are trying to put out the fire.