Tuesday, January 22, 2008

Policy and Precedent

The Federal Open Market Committee (FOMC) made a major policy announcement earlier this morning. The 75 basis point drop on both the target for the Fed Funds rate and the discount rate is very significant, speaking to the concern about the current situation in the financial markets. As rate drops go, it ranks up there with the Fed's announcement in 1991 of a drop of 50 basis points in Fed Funds and 100 basis points in the discount rate. (A basis point is one one-hundredth of a percent, thus 100 basis points is the equivalent of one percent.) At that time, the U.S. was already in recession and the economy had not responded to a series of smaller cuts. I've often thought of changes of this magnitude as the "whack up the side of the head" approach to policy. While that terminology is probably not in anyone’s handbook other than mine, it refers to the old saw that when trying to get a mule to do what you want, you may need to given them a whack to first get its attention. Certainly back in 1991 one could make that argument. The economy had pretty much ignored earlier moves and had not turned around. The cut reinvigorated the economy, particularly the real estate market.

I'm not sure this action qualifies as the "whack up the side of the head." I don't think the economy as succumbed to the r word. The statement makes clear the Fed is concerned with the down side risks to the economy. This is in line with the Fed's dual mandate to maintain maximum sustainable growth as well as price stability. However, I believe this is also a case of the Fed moving to maintain an orderly financial market. Part of the Fed's responsibility is to maintain liquidity and help markets maintain order. One could certainly make a case for a lack of order in global financial markets during the past couple of days. In some ways, this event smacks more of 1987 than of 1991. But either way, it provides an excellent opportunity to teach about monetary policy and the central bank's role in the U.S. economy. "Real life" makes things so much clearer than textbook examples. It may even justify teaching the topic out of order after providing some basic background. What do you think?

Are you continuing to stick to the lesson plan, or are you taking advantage of this teachable moment? And what are you doing specifically if you're doing the latter? Your colleagues reading this blog and I want to know.

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