Throw out all the econometric models—we are now officially into uncharted territory.
For the last quarter-century, the Federal Reserve has basically used one tool—the Fed funds rate—to run monetary policy. When the economy was running too hot, the Fed raised rates. When the economy was running below potential, the Fed cut rates. It was simple, and at the core, straightforward.
But today's announcement by the Fed is something very different: a window into a newfangled world where monetary policy is as innovative as the financial markets. Over the past 25 years, Wall Street wizards have moved away from plain-vanilla equity and debt, and constructed a staggering array of derivatives and other new forms of financial instruments. But while these instruments have been highly beneficial for growth, economists and policymakers have repeatedly worried about a major financial crisis triggered by out-of-control derivatives.
New Tools for New Times
The long-feared crisis is now upon us—and the Fed, led by Chairman Ben Bernanke, is responding with a wave of new policy instruments. First came the Term Auction Facility, introduced in December, which allowed the Fed to better pump out money to banks without cutting interest rates. That was good, but it wasn't enough.
The Term Securities Lending Facility (TSLF)—announced Mar. 11—is a more powerful and more precise tool for addressing the dislocations in the credit market. It is aimed at the heart of the current problems: mortgage-backed securities. The problem is that nobody knows what these complicated securities are really worth, so they are clogging up bank balance sheets and impeding the normal flow of credit. Without getting into technical details, the TSLF elegantly sidesteps the problem—the big banks can use these securities as collateral, and borrow Treasuries from the Fed.
The intended result: more lending and borrowing, as nature intended.
Impossible to Predict the Impact
How effective will the TSLF be? It moved the markets Mar. 11, but no one is certain about its long-term impact. Still, what's important is that the Fed, no longer stuck in the past, is developing the policy tools necessary to deal with today's financial markets. If Bernanke and Co. can invent two new ways of dealing with financial crisis, they can invent more. In fact, for all we know, there is a secret war room of young economists in the basement of the Federal Reserve, charged with creating even more new policy tools with strange acronyms.
The downside, though, is that the behavior of the economy and the financial markets has become highly unpredictable and will continue to be for the foreseeable future. Economists knew roughly how changes in the Fed funds rate would affect the economy. For example, econometric models showed, from historical experience, that it would take 12 to 18 months for a rate cut to have its full effect on output.
But the TSLF has no track record. Will its impact be immediate, or felt over a longer period? There's no way to tell. Will it help lending, or primarily be felt in the stock market? Forecasters are inevitably clueless, because there is no historical record.
Here's what we do know. A 21st century economy demands 21st century monetary policy—and that's what we seem to be getting.