By tightening monetary policy during the past year, the Federal Reserve Board has gotten back on track, but it should refrain from further tightening. There are signs the Fed believes the economy is growing too fast, so it sends signals that it will continue to raise short-term interest rates in an effort to slow down our economy. Big mistake!
The supply-side tax-rate reductions of 2003 continue to create powerful incentives for work, saving and investment, which are driving economic growth close to 4 percent. New jobs and new businesses are being created aplenty. It would be wrong for the Fed to choke off this growth out of a misguided belief that "too much" economic growth is inflationary and manifesting itself, in part, in a so-called housing bubble. Economic growth does not create inflation; it soaks up excess money supply, dampens inflation and raises tax revenues at all levels of government.
Alan Greenspan called it a "conundrum" when he testified recently before the congressional Joint Economic Committee. What's puzzling the Fed chairman is the fact that the central bank has been "tightening" credit for a year now - i.e., raising short-term interest rates by 2 percentage points - and yet long-term rates continue low by historic standards. Rates on 10-year Treasury notes have fallen by more than half a point since last June when the Fed began its tightening spree. Yields on corporate bonds have fallen a full point.
Thankfully, the Fed's interest-rate targeting is having the opposite effect of what it intends. Despite its "tight talk" and efforts to slow the flow of new money into the economy, the central bank has added liquidity, i.e., creating more money than it intends. That's what happened in reverse in the late 1990s, when the Fed thought it was adding liquidity but in fact was draining liquidity and creating a worldwide deflation. As the Fed squeezed the economy in the name of "pricking" a stock-market bubble, demand for liquidity fell. In order to prevent market interest rates from falling below its interest-rate target, the Fed continually had to drain liquidity to prop up interest rates, and in the process it put the world economy through a deflationary wringer.