Alan Reynolds

After the Fed cut the fed funds and discount rates a quarter of a point, the usual pundits offered the usual opinions about the brilliance or foolishness of that move. To think sensibly about what the Federal Reserve does, however, it helps to start with reasonable (low) expectations about what any central bank can do.

Congress gave the Fed enormous power to mess things up but no mandate about what the central bank's goal should be. Lacking any legitimate job description, the dozen members of the Federal Open Market Committee (FOMC) came to think of themselves as expert central planners in charge of fixing whatever problems they could dream up. At this moment, the FOMC central planners proclaim that the economy "has yet to exhibit sustainable growth."

From the fourth quarter of 2001 through the first quarter of this year, the economy grew at an annual rate of 2.7 percent. That was slow, but there is no evidence to suggest it was not or is not "sustainable." By saying the economy's growth is not "sustainable," did the Fed mean growth would grind to a halt were it not for this miraculous quarter-point dip in the interest rates on bank reserves?

In reality, the headline statement about growth not being sustainable meant nothing at all. "The committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal." That is, the FOMC thinks the economic growth -- which has heretofore been unsustainable -- is nonetheless likely to be sustained. And it boldly forecast a 50-50 chance that things could get better or worse.

The Fed started issuing such absurd "balance of risk" statements a few years ago -- implying Fed policymakers alone could achieve the perfect balance between too little economic growth and too much. The hidden assumption behind that balancing act is that inflation supposedly arises from excessive real growth. Unfortunately, that assumption makes inflationary recessions conveniently impossible, by definition, which also makes dangerous nonsense of the whole ritual.

The latest FOMC missive takes this foolhardy Keynesian trade-off even further, predicting that "the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation ..." A "substantial fall in inflation" is now officially "unwelcome." Why? Because lower inflation is assumed to be associated with slower economic growth, and vice-versa.


Alan Reynolds

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