Quotes of the Day

Central banks are supposed to "lean against the wind." Monetary policymakers increase overnight interest rates when strong growth is threatening to push up inflation, and they reduce rates when economies begin to slide into recession and deflation. But what to do when the wind is a cyclone? That is the question confronting the U.S. Federal Reserve, the European Central Bank and their counterparts as the financial storm spawned by U.S. subprime mortgages continues to wreak havoc across credit markets. The resulting higher borrowing rates and tighter credit standards threaten to pull the U.S. economy into recession.

Such times complicate the standard central-bank playbook — which includes the seminal Taylor Rule. Proposed by Stanford economics professor John Taylor in the early 1990s, the Taylor Rule provides a formula for raising and lowering policy rates based on two variables: whether inflation is above or below the central bank's target, and whether economic growth is above or below its "full employment" potential. If inflation is at target and the economy is operating at full employment, then the Taylor Rule says that the central bank should set the overnight interest rate at a fixed "neutral" level, which Taylor estimated was 4% for the U.S. with inflation running at a targeted rate of 2%.

But the Taylor Rule provides less guidance when the neutral interest rate is shifting rapidly due to changes in financial conditions, which is exactly what is happening right now. Banks and other lenders are demanding a higher premium for lending to households and companies. To prevent the cost of borrowing from increasing — to keep interest rates at neutral, in other words — the central bank must cut the policy rate. If the central bank wants then to provide monetary stimulus to an ailing economy, it must reduce the policy rate even further to get below the newly depressed neutral rate.

If the central bank does not act quickly enough — and deteriorating financial conditions create a self-perpetuating feedback loop with a collapsing economy — the bank may end up just "chasing the neutral rate down" without reaching the level needed to jump-start demand. Japan's experience in the 1990s provides a cautionary tale: even 0% rates failed to resuscitate the economy.

U.S. Federal Reserve Chairman Ben Bernanke appears intent on avoiding such mistakes. He pledged during recent congressional testimony to "act in a timely manner as needed to support growth and provide adequate insurance against downside risks." And Fed actions speak louder than words: the 1.25 percentage point reduction in the overnight policy rate at the end of January was the most rapid cut by the U.S. central bank in recent history.

The Fed is also taking other steps. It recently expanded on a program introduced late last year to inject billions of dollars of liquidity into the banking system. The reason is the continued rise of key interest rates — including all-important mortgage rates — due to financial market distress. We are therefore poised not only to see further policy-rate cuts, but also continued nontraditional central-bank actions to get credit markets working again, including possible outright purchases of U.S. mortgage-backed securities.

It is not clear that even these aggressive actions will be sufficient to avoid a major U.S. slowdown or recession, given the deadweight of the sinking housing market. With the standard playbook and tools like the Taylor Rule less relevant to the immediate challenges at hand, central bankers are finding themselves looking at stock and bond markets to help them decide what to do. The markets in turn are looking back at central banks, trying to guess how monetary policy will affect asset prices. It reminds us of the early Ozzy Osbourne lyrics: "You, looking at me, looking at you .../ I know you know I know too/ Is it me or is it you?"

It is likely to be both in 2008, with the global economy and Bernanke's legacy as Fed Chairman hanging in the balance.

Paul McCulley and Ramin Toloui are portfolio managers at Pacific Investment Management Co. (PIMCO), one of the world's largest fixed-income investment firms.

• Paul McCulley and Ramin Toloui