Worries about the Fed (a wonkish post)

The signs point increasingly to an imminent, or perhaps already begun, recession. Ben Bernanke has in effect pledged to do whatever is necessary. But does the Fed have what it takes?

Some musings:

Monetary policy mainly exerts its influence through housing: high interest rates squeeze home construction, low rates encourage it. Interest rates have much less direct effect on business investment. The reason? Housing lasts much longer.

Suppose you take out a loan to buy a machine whose economic life is only 5 years — which is highly likely, given both physical wear and tear and technological obsolescence. How much difference does it make whether the interest rate on the loan is 4 percent or 6 percent? Not much: the monthly payment on a 5-year loan at 4% is less than 5% lower than the monthly payment on a loan at 6%. So interest rates don’t have much effect on business investment.

On the other hand, suppose you buy a house with a 30-year mortgage. The monthly payment on a 4% mortgage is more than 20 percent lower than on a 6% mortgage. So interest rates make a lot of difference to housing.

So here’s what normally happens in a recession: the Fed cuts rates, housing demand picks up, and the economy recovers.

But this time the source of the economy’s problems is a bursting housing bubble. Home prices are still way out of line with fundamentals:

INSERT DESCRIPTIONCBO price-rent ratio

So: is it even possible for the Fed to cut interest rates enough to create a renewed housing boom? (The Fed can cut the overnight rate all the way to zero, but even large changes in the overnight rate can have only modest effects on mortgage interest rates, if the market perceives those changes as temporary.) If it can’t, how much can the Fed really do to help the economy?

Those aren’t rhetorical questions. I’m actually not sure how bad things will get — remember, we still have help from booming exports. But it’s not too hard to tell stories in which monetary policy doesn’t have enough mojo to deal with our current problems.

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