Knight-Ridder/Tribune Media Services, November 22, 1998
Most people tend to evaluate events relative to their expectations: when the Washington Redskins won their first game this season after seven straight losses, fans were elated.
The Federal Reserve is lucky that it is judged in the same manner: last week’s quarter-point cut in short-term interest rates was as much as anyone expected, and so they will not get much criticism.
But what if the Fed were held to a different standard? What if we asked, "how can the Fed help the economy grow and promote full employment as much as possible, while keeping inflation in check?"
This is not an outrageous demand. In fact, this is what the Fed is legally supposed to do.
By this standard, the Fed does not measure up very well. Our economy is slowing, and so is job growth. The manufacturing sector has been especially hard hit by the depression in Asia. Japan, the world’s second largest economy, is in a recession with no obvious end in sight. In the Fed’s own announcement of the rate cut, it cited "unusual strains" in financial markets, and few economists would argue that the global financial instability of recent months is fully behind us.
Last week the Paris-based OECD (Organization for Economic Cooperation and Development) cut its forecast for U.S. economic growth next year from 2.1% to 1.5%, even with the assumption that markets remain calmed and interest rates continue to decline.
With all these storm clouds on the horizon, there is a strong argument that interest rates should be very low in order to stimulate economic growth. But in fact they are very high, even after the Fed’s quarter-point cut. Many people do not realize this, because they are looking at the nominal rate-- now 4.75% for the Federal Funds rate.
But it is the real rate-- that is, after subtracting inflation-- which affects economic activity. Since inflation is currently running at only 1.5%, we have real short-term interest rates that are very much higher than they have been for most of the last 40 years. The only legitimate argument for maintaining such high real interest rates would be to fight inflation. But inflation is now at a 34-year low.
The Fed’s track record in recognizing and counteracting the dangers of economic contraction is not very good. For example, consider the events leading up to our last recession. From the first quarter of 1988 to the first quarter of 1989, the Fed raised interest rates enormously- from 6.5% to 10%. As the economy slowed, the Fed began lowering interest rates-but very timidly, in quarter-point increments. A year later, on the eve of the recession, the Federal funds rate (the Fed's key interest rate) was still at 8.25%. The result was predictable: the economy lapsed into recession in July of 1990.
Two months into the recession, Fed Chair Alan Greenspan was as yet unaware of the contraction: "We have not tilted downward yet," he announced in September of 1990.
The Fed also slowed the economy unnecessarily in 1995, with a string of rate hikes beginning in February of 1994 that doubled short-term rates within a year. At the time, the Fed was trying to keep the unemployment rate from falling below 6%, on the theory that such "low" unemployment would cause inflation to accelerate. Fortunately, the Fed has since abandoned that theory, and allowed unemployment to sink to its current level of 4.6%.
The situation today is complicated by the role of the stock market, whose run-up to overvalued levels has fueled much of the economy's growth over the last seven and a half years. If the market retreats to prices more proportional to companies' potential earnings, consumer spending will inevitably fall. While it would not be legitimate for the Fed to lower interest rates in order to prop up an overvalued stock market, it is important to protect the rest of the economy from the effects of a serious decline in stock prices.
Will the Fed repeat its past mistakes and maintain unnecessarily high interest rates as the economy slows? No one can say for sure, if only because the future course of the economy is so difficult to predict. But one thing is clear: the Fed could do a lot more to protect us from the enormous economic and social costs of a downturn in the economy.