Considered as amongst the most powerful of tools within a Central Bank's arsenal, the effectiveness of monetary policy depends very much on the economic environment in which it is being applied. There are basically two situations in which monetary policy becomes totally ineffective:
When the transmission system is faulty, whereby a change in monetary policy fails to influence economy wide lending rates. A severe credit crunch, such as the one being currently experienced, can significantly diminish the effectiveness of a change in interest rates. Despite a rate cut, for example, the economy fails to be stimulated.
The second situation, known as the liquidity trap, is related to the differential between the target rate from the zero percent nominal rate. The closer the target rate is to zero percent, the less room a central bank has to further stimulate the economy using monetary policy as a tool. At some point close to zero, the effectiveness of monetary policy disappears.
The global economy is currently experiencing a credit crunch which is steadily eroding the effectiveness of monetary policy. The U.S. Federal Reserve is in a worse situation because it is facing a double whammy with a credit crunch on one hand and a potential liquidity trap on the other hand (considering that with the latest move, the target rate now stands at one percent, leaving very little room for maneuver if more stimulation is required). The situation is reminiscent of Japan in the 90's where the Bank of Japan became impotent as it lost the effectiveness of its monetary policy tool after the nominal rate was cut to zero.
The obvious remedy in the case of the U.S. would seem to involve solving the transmission problem as it would boost the amount of stimulation into the economy. Unfortunately it is more easier said than done as it would require restoring confidence that has been severely impaired.
When the transmission system is faulty, whereby a change in monetary policy fails to influence economy wide lending rates. A severe credit crunch, such as the one being currently experienced, can significantly diminish the effectiveness of a change in interest rates. Despite a rate cut, for example, the economy fails to be stimulated.
The second situation, known as the liquidity trap, is related to the differential between the target rate from the zero percent nominal rate. The closer the target rate is to zero percent, the less room a central bank has to further stimulate the economy using monetary policy as a tool. At some point close to zero, the effectiveness of monetary policy disappears.
The global economy is currently experiencing a credit crunch which is steadily eroding the effectiveness of monetary policy. The U.S. Federal Reserve is in a worse situation because it is facing a double whammy with a credit crunch on one hand and a potential liquidity trap on the other hand (considering that with the latest move, the target rate now stands at one percent, leaving very little room for maneuver if more stimulation is required). The situation is reminiscent of Japan in the 90's where the Bank of Japan became impotent as it lost the effectiveness of its monetary policy tool after the nominal rate was cut to zero.
The obvious remedy in the case of the U.S. would seem to involve solving the transmission problem as it would boost the amount of stimulation into the economy. Unfortunately it is more easier said than done as it would require restoring confidence that has been severely impaired.
