There is agreement among many analysts that the Fed should pursue a low interest rates policy in order to prevent the US credit crisis from degenerating into a recession. On what grounds are we told that? The bottom line is that monetary policy is supposed to fine-tune the economy by targeting inflation and the output gap. Thus, monetary policy is supposed to become tighter when there are fears of inflation, and looser when there are fears of a recession and no sign of inflation. Consequently, the fed’s recent moves to lower interest rates seem perfectly orthodox.The resulting policy prescription is to let the illness take its course:
This focus on macroeconomic aggregates ignores any other effect that interest rates can have on the economy. It totally ignores that interest rates are a price which affects many allocative decisions and has important distributive consequences...
The problem is that low interest rates not only stimulate the economy, they do plenty of other things. In other words, focusing only on GDP has costs and may generate mounting problems—the low rates policy makes a current recession better, but the next one may be worse.
One reason why the US economy is less inflation-prone than in the past is that a bigger share of any increase in domestic demand is absorbed by imports: the economy is more open than it used to be. Thus, instead of having “overheating” because demand is greater than supply, the gap between the two is filled by trade deficits. Hence, low rates stimulated consumer spending and the trade balance deteriorated by two percentage points of GDP. The US is rapidly accumulating foreign debt and that may lead to a brutal correction with a sharp drop in consumer spending and a large depreciation of the real exchange rate. In fact, that correction may have already begun. Yet the Fed is not supposed to look at the net foreign asset position of the US economy, even though both its deterioration and rising inflation are the symptom of the same problem – excess domestic demand.
The other issue is asset prices. When interest rates are very low, and expected to remain so, asset prices can be very high.... In particular, low interest rates may start asset bubbles...
All this suggests that the US has to go through a recession in order to get the required correction in house prices and consumer spending. Instead of pre-emptively cutting rates, the Fed should signal that it will not do so unless there are signs of severe trouble (and there are no such signs yet since the latest news on the unemployment front are good) and decide how much of a fall in GDP growth it is willing to go through before intervening. As an analogy, one may remember the Volcker deflation. It triggered a sharp recession which was after all short-lived and bought the US the end of high inflation.If one views the current economic situation as "unsustainable" - i.e., that the low saving rates and large current account deficit cannot go on forever, some significant reallocation of productive resources is necessary. In particular, to get to a more "balanced" state the US needs to consume less, particularly fewer imports, and export considerably more, so we need fewer people working in consumption goods industries and more people in exporting industries. The question is whether this reallocation could be achieved without a recession - if workers could shift sectors instantly, no loss of output is necessary. However, in practice, reallocation entails "adjustment costs" - jobs in one sector need to be destroyed and people need to go through a search (and possibly retraining) process to find a jobs in another sector. In the US, there is a constant "churn" in the labor market as millions of jobs are continuously being destroyed and created, but a major reallocation would entail even more turnover than usual.
Saint-Paul is essentially saying that a low interest rate policy by the Fed is delaying this needed adjustment. It seems clear that monetary policy contributed to increases in asset prices (stocks in the late 1990's, houses more recently), and when asset prices increase, households do not feel the need to save as much - i.e. the consumption function shifts up. This is the "serial bubble blower" critique of the Greenspan Fed. There's some truth in it, but this argument may overstate the power of monetary policy - the Fed is targeting a short-term nominal interest rate. The long-term real interest rates that affect saving and investment decisions are influenced by the Fed's actions, but other factors come in to play. In particular, inflows of foreign saving have played a major role in keeping long term rates low, regardless of the Fed's actions. If our foreign creditors decided to cut back on their purchases of US assets, long term rates could rise, even if the Fed was keeping the fed funds target low - i.e., the yield curve would become much steeper.
One thing that is helping is the decline of the dollar - US exports are becoming cheaper and imports more expensive. This is starting to show up in a decreasing trade deficit. Low interest rates contribute to the dollar's weakness, so in this regard Saint-Paul's prescription would be counterproductive.
The Volcker analogy is not necessarily an encouraging one: although maybe there was no painless way to end the inflation of the 1970's (it was a "disinflation," not a "deflation"), the "double dip" recession in the early 1980's saw the highest unemployment rates since the depression. The high interest rates - partly due to the Reagan-era deficits, as well as tight monetary policy - led to an appreciation of the dollar and a large current account deficit.