Stock Market Plunge: Can the Fed Do Anything?

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Ben Bernanke (Larry Downing / Reuters)

Will Ben Bernanke ride to the rescue? And how?

In recent months the Federal Reserve Chairman has given the impression that he and the other policy members on the Fed’s board have no plans to launch any new stimulus efforts. But the question now is whether the market gyrations, including a 600 point drop in the Dow Jones industrial average on Monday, will change that stance. We will soon find out. The Fed’s policy committee meets on Tuesday for its monthly meeting. It will release a statement at 2:15 indicating whether the Fed will take new action to boost the economy or stay on the sidelines for now.

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Market plunges like the over 600 point drop in the Dow Jones industrial average on Monday have caused the Fed to act in the past. In August 2007, with the stock market falling, the Federal Reserve cut short-term interest rates for banks in order to stabilize the market. The problem is that four Augusts after it first acted to calm the markets in the early days of the financial crisis, the Fed is in a very different position. The Fed has faced a bruising year of criticism for the steps it has already taken to stabilize the economy. And short-term interest rates – which are the ones the Fed directly controls – are already at zero. Still, the Fed has some options. And I think it is unlikely to sit around and do nothing. Here’s why:

Option No. 1 would be another round of bond buying to drive down long-term interest rates. Bernanke and the Fed have come under a lot of criticism for its last round of so-called quantitative easing, which was dubbed QE2. Still, I think QE3 is a strong possibility. Allan Meltzer, a top Fed historian, says it would be wrong of the Fed to undergo another round of bond buyer. He says QE2 only produced a temporary increase in jobs and output. At the same time it boosted inflation.

But I don’t think that will stop Bernanke. First of all, Bernanke is a student of the Great Depression and history had taught us the problem with the recovery out of that recession was there wasn’t enough liquidity. Milton Friedman, the famous monetary economist, argued that the best way for the Fed to boost the economy was to increase the money supply. Overall, money supply does appear to have grown significantly during the recession. But the measure of the number of dollars actually getting into the system – the m2 multiplier – has been falling this year, after rising for much of last year. That argues the Fed needs to do more.

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Second, the stock market usually is a leading indicator for the economy. Large market drops usually indicate slower growth or even a recession. In the past five days the market has dropped 13%. The stock market has only dropped that much or more in a five-day stretch in three other periods. Two of the times in did so – in 1987 and 2008 – both preceded a recession.  The third time the market had a week-long 13% plus losing streak was in 1962, which was at the end of recession and the beginning of a long period of prosperity. No indicator is perfect. But stock market drops do tend to indicated economic problems. And right now other economic indicators, including the report a few weeks ago that GDP grew much slower in the first part of the year than many people thought, do indicate problems. Lastly, while inflation was rising in the early part of this year, it appears to be falling again, and not just in America but around the world. So fears that recent Fed moves have created long-term inflation are mostly unfounded.

Which brings up to Option 2: Raise the Fed’s inflation target. Traditionally, the Fed has set 2% as it its annual inflation rate. But if it were raise that target to say 4% or 5%, it would show to the economy that it is willing to allow significant growth before it began cutting interest rates again. Higher inflation would also help the government and consumers in general pay off their debts. Inflation tends to increaseIt’s a riskier move because once you take the lid off inflation it may be hard to get that genie, it may be hard to get inflation back under control.

Still, trying to boost inflation might be the way to go. Increasingly that has become one of the favorite choices of top economists for solving the current economic crisis and debt problem in one more. Kenneth Rogoff, a Harvard Economics professor who co-authored This Time is Different – which stress the problems of governments taking on too much debt – thinks that the Fed should triple its inflation target to 6%.  Greg Mankiw, who was an economic adviser to George W. Bush, has advocated the Fed should push for higher inflation as well.

Stephen Gandel is a senior writer at TIME. Find him on Twitter at @stephengandel. You can also continue the discussion on TIME‘s Facebook page and on Twitter at @TIME.

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