Some observers say the Federal Reserve is once again over-stimulating the economy because real interest rates are negative (they dont compensate for the loss of purchasing power). Rates that low encourage people to borrow and spend rather than save and invest. And when people do invest, they are driven into riskier investments in a search of higher yields. In short, negative rates perpetuate the environment that got the U.S. into its financial mess.
True, negative interest rates can have such effects. But I wonder if they are something to worry about in the midst of a financial crisis. Maybe it would be better to ensure the system is stabilized before re-focusing on what has to be done to rein in easy money policies.
Actually, as I understand, the Fed is right now trying to keep interest rates from falling as much as the market wants. There has been a flight to the safety of U.S. government treasuries, which has pushed their yields way down. But the Fed has not followed treasury rates down to the same extent. It kept its discount rate higher by selling treasuries (which also drains cash from the financial system and offsets liquidity by the Fed’s rescue efforts). My guess is the Fed is following this course to lower the risk of a run on the U.S. dollar and to keep inflationary expectations at bay.
If and when the system stabilizes, the Fed ought to address its historic bias toward over-stimulation. The agency is now conducting an internal review of its past hands-off policy toward asset bubbles, as reported in Financial Times of London articles over the past week or so. Hopefully some changes will come of that. One possibility is greater use of regulatory tools to head off repeats of the subprime debacle. Another, which I have posted on before (see April 9 post, Alan Greenspans excuses), is formal or informal inclusion of asset prices in the inflation target.