Bruce Bartlett

Two weeks ago, the Federal Reserve again raised short-term interest rates. The federal funds rate now stands at 3.25 percent. This is the rate banks charge each other on overnight loans and is generally the lowest interest rate in existence, setting a floor for all other rates. In June 2004, it stood at just 1 percent.

 So far, financial markets have shrugged off the Fed's actions. Indeed, mortgage rates are actually lower now than they were before the Fed started tightening, fueling a housing "bubble" in the opinion of many economists. The lack of response in markets suggests that the Fed will have to tighten much more than it originally planned in order to achieve its goal of keeping inflation in check.

 Despite the paucity of evidence that Fed tightening is having any meaningful economic impact, Fed officials are very concerned that it could come about quite suddenly. The Fed raises interest rates by tightening the money supply, the growth of which has fallen sharply over the last year. Historically, this always leads to an economic slowdown with a lag of about 18 months.

 But long before the impact of Fed tightening shows up in the gross domestic product figures, it will begin impacting on financial markets. The danger is that with markets so interconnected, with so many extremely complex linkages, problems can quickly spread, affecting areas far removed from the original source. For example, some years ago, the failure of a small Iowa bank almost brought down one of the largest banks in Chicago, which threatened the health of the entire banking system before the Fed engineered an emergency bailout.

 On June 14, Federal Reserve Board Governor Susan Schmidt Bies issued what for the Fed is a pretty explicit warning about the systemic dangers in the housing bubble. Her comments are worth quoting at length.

 "We worry," she said, "that borrowers could become increasingly speculative, buying beyond their means and hoping for asset price appreciation -- whether they are buying for their own use or strictly for the sake of investment. We worry that competitive pressures could drive banks to lower their underwriting standards, implicitly encouraging such speculation. And we worry that, in the inevitable downturn, credit quality could deteriorate to the extent that some banks could experience significant losses."


Bruce Bartlett

Bruce Bartlett is a former senior fellow with the National Center for Policy Analysis of Dallas, Texas. Bartlett is a prolific author, having published over 900 articles in national publications, and prominent magazines and published four books, including Reaganomics: Supply-Side Economics in Action.

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