Global Monetary Policy: A Theory in Progress

The Federal Reserve’s quantitative easing program in response to the Great Recession in 2008-09 resulted in the Fed buying more than $4T worth of Treasury bonds and mortgage backed securities to increase the supply of money in the financial system.

As the economy recovered, the Fed began to reverse that program, slowly reducing its portfolio of bonds. According to classical macroeconomic monetary policy, the plan was to have nearly robotic increases in the Fed Funds rate toward the theoretical natural rate of 3-3.5%. The theory of the natural rate is of a not-too-high not-too-low interest rate for hands-off monetary policy for the economy. Achieving the natural rate is a means of re-arming the Fed’s store of ammunition for managing the economy in any future unanticipatable economic collapse.

But monetary policy can be a punchbowl for politicians concerned with re-election. Cutting the Fed Funds rate in the U.S. will stimulate the economy by reducing the cost of servicing debt and encouraging investment. The impact, of course, all other things the same, is a reduction in the value of the currency. Domestic voters, however, may notice little side effects of a reduction in purchasing power.

The Fed raised interest rates four times last year, drawing severe criticism from President Trump. While the American economy is robust and unemployment historically low, the effects of the president’s $1.5T tax cut are waning and his trade war has begun to hurt some American industries, as well as slow global economic growth. Under pressure from the President, including threats of replacing the newly installed Federal Reserve chairman, the Fed reversed course and began to consider the potential weaknesses in the economy.