In the simplest terms, the idea behind a lowering of the fed funds rate is for the incentive to hold money in the bank to be so low that many people (mostly investors, or rather, investment banks) will use the money. The use of said funds is then said to spur on spending for capital (jobs and the like) in the economy.
Does it work? My best guess, maybe. But, along with many others like Kevin Hall at McClatchy Newspapers, Milton Friedman – whom Hall mentions, and other economists always want to point out is that using monetary policy (the federal reserve and its funds rate) and fiscal policy need to be thought about simultaneously. That is not to say that one cannot use both of them at the same time, but merely to understand that they both have a probabilistic effect the economy.
Greg Mankiw posed that proper question just a few days ago. He wrote that if a reporter could ask any committee member on the fed any question, it would be:
If the economy now gets the fiscal stimulus being proposed (about 1 percent of GDP), does that mean that the Federal Reserve will cut interest rates less than it otherwise would?
My follow-up questions:
If the answer to the first question is No, then ask, Why the heck not? Monetary and fiscal policy are two tools available to increase the aggregate demand for goods and services. The goal here is to prop up demand sufficiently to maintain full employment without causing inflation. If the U.S. government is using fiscal policy more, it should use monetary policy less.
If the answer to the first question is Yes, then ask, How much higher will interest rates be kept as a result of the fiscal stimulus? And is it really better to have a fiscal stimulus and higher interest rates than a smaller deficit and lower interest rates?
But let us not forget that the economy has a way of doing what it wants to do no matter the coaxing (simply think of how irrational our partisan political hatred can be). Comedian, Lewis Black says that the economy goes up and down and no one knows why. Well, to some extent, he is speaking truth because many economists are willing to admit that we don’t know where we are economically until an event has already passed us, and we have enough time to research the economic past.
Right now, your best bet to figure it out may as well be to bet…on Intrade that is. Even as much as people want put behind them the sub-prime mortgage losses that larger banks have written down losses on, there may still be more ahead of us. As Paul Krugman and Robert Samuelsson have mentioned separately, the falling asset prices on homes is the event to really worry about because we may not be ready for the shock as to how much we were willing to pay just because someone on the other side of the desk said, “Oh, well, home prices will continue to rise, and you can always re-finance.”
I hate to say it, but Krugman’s doom and gloom scenarios may have some possibility to them after all, and if so, things may have to get worse before they can get any better.