By Steven K. Beckner

NEW YORK (MNI) – San Francisco Federal Reserve Bank President John
Williams said Friday that a “partially clogged” monetary transmission
mechanism means that the Fed must use its monetary policy tools “even
more than usual.”

Williams, a voting member of the Fed’s policymaking Federal Open
Market Committee, said the depressed housing market is just one factor
cooling aggregate demand and suggested the need for continued, if not
enhanced monetary accommodation.

He cited models suggesting that, if it was possible, the federal
funds rate should be “substantially negative,” and said concerns about
regional overheating due to low interest rates are “largely
hypothetical.”

Williams, in remarks prepared for a Monetary Policy Forum sponsored
by the University of Chicago Booth School of Business, was commenting on
a report on housing and monetary policy by four prominent economists.

The paper states that “headwinds … may require a more aggressive
monetary response than in normal downturns.”

“I entirely agree,” Williams commented, before going on to suggest
that the FOMC may need to consider easing more than it already has.

“A range of monetary policy rules suggest that the target nominal
funds rate should have been substantially negative in recent years,” he
said.

To approximate a negative federal funds rate the Fed has done two
rounds of “quantitative easing” exceeding $2 trillion and is currently
conducting a $400 billion “Operation Twist” to further lower long-term
interest rates.

But Williams said “the monetary transmission mechanism is partially
clogged.”

“Credit market frictions make refinancing and other housing
activity less responsive to changes in interest rates,” he said.

“Fortunately, the monetary transmission mechanism doesn’t work
solely through its effects on housing, or even through balance sheets
and collateral constraints more generally,” Williams continued.
“Monetary policy also affects the economy through wealth effects,
household intertemporal substitution, the user cost of capital
generally, and exchange rates, among other mechanisms.”

“But suppose monetary policy is less powerful than usual,” Williams
said. “That suggests we need to move our monetary instruments even more
than usual to achieve our employment and price-stability objectives.”

The paper suggests that an easy money policy might have a more
potent impact in regions which have been less hard hit by the housing
crisis than others. So “by attacking a big output gap in one region, we
could be overheating other regions.”

But Williams said “this concern is largely hypothetical. It’s not
the case that some areas are overheating and others are languishing.
Every region is facing substantial common headwinds.”

Apparently referring to targeted housing policies suggested by a
Fed white paper last month, Williams said “the partially clogged
transmission mechanism could suggest that you don’t do more of
everything across the board, but concentrate on policies that affect
particular problem areas.”

“For example, purchases of mortgage-related securities appear to
have reduced mortgage rates significantly, making them particularly
useful given the weakness in the housing sector,” he said. “In addition,
as discussed in the paper, fiscal policies could directly address the
housing-related headwinds, potentially yielding two benefits-a stronger
housing recovery and more powerful effects from the existing monetary
stimulus.”

Although the housing crisis “has led to a persistent shortfall in
aggregate demand,” Williams said the collapse in home prices and
residential construction “has not been the only factor weighing on
aggregate demand.”

“In particular, the sluggish recovery has not been limited to
regions hard-hit by the housing downturn,” he elaborated. “Instead,
fallout from the broader financial crisis also reduced aggregate demand
through a variety of nonhousing channels.”

What’s more, he said, “the resulting large and persistent output
gap is national in scope, which calls for strong countercyclical
monetary policy.”

Although there were wide divergences in home price and construction
declines from region to region during the downturn, Williams said that
there have been much fewer differences during the recovery.

“Housing was important in explaining regional differences during
the downturn,” he said. “But once the downward adjustments took place,
the disappointing pace of recovery has been similar across regions,
suggesting broad-based factors have been at work.”

Williams said “this evidence supports the view that house-price
declines were not the entire story behind the deep recession and slow
recovery.”

** Market News International **

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