The Economy: Where's the bounce?

Monetary policy operates through multiple channels to affect the economy. The movement of short-term interest rates is just one of those channels. This channel does appear to be working. Adjustable rate mortgages have come down sharply. Auto companies are using the short-term funding market to finance increasingly generous sales incentive programs. However, to be fully effective, monetary policy also needs to affect long-term interest rates, the equity markets, and the foreign exchange value of the dollar. None of these factors has responded to lower short-term interest rates. Long-term interest rates have edged down only modestly since the beginning of the year. Thus, any activity that is tied to longer-term financing--for example, most home mortgages and corporate borrowing--has not be greatly stimulated. Additionally, equity markets have yet to recover despite sharply lower short-term interest rates. This is because the outlook for corporate profits is deteriorating even faster than interest rates are coming down. Consequently, equity markets continue to languish following last year's debacle. The negative wealth effects from the decline in equity market is depressing both consumer and corporate spending. Finally, the foreign exchange value of the dollar has increased despite the Federal Reserve's actions. The stronger dollar makes exports more expensive in international markets and imports less expensive in domestic markets. This depresses exports and boosts imports, dampening the domestic economy. The transmission of monetary policy changes to the economy is quite complex. However, while short-term interest rates are sharply lower, the other channels of monetary policy appear to be clogged. Until either equity markets begin to recover or the dollar's value starts to retreat, the economy's response to the Federal Reserve's policy actions is likely to be muted.

First published on BankersOnline.com 8/6/01