Today the situation is reversed. The Fed thinks it is "tightening" monetary policy and draining liquidity. In fact, it appears liquidity continues to increase at a fairly rapid but not unwarranted rate. The annual rate of growth of the Fed's balance sheet - the rate at which the central bank is purchasing bonds from the open market - rose from 4.5 percent in June 2004 to 7 percent in November of last year. During the past six months, the Fed's balance sheet has been growing at about 6 percent. As one analyst at the Ludwig von Mises Institute wrote recently, "The Fed has been talking tough while acting loose."
The level of lending to businesses makes the point. When the mortgage-refinancing boom came to an end a year ago, nonbank lenders, such as hedge funds and mutual funds, became an increasingly important source of loans to private business borrowers. Despite rising short-term interest rates, credit-worthy small- and medium-sized businesses have had no problem obtaining loans during the period of Fed tightening.
When the Fed inches short-term interest rates higher, it unintentionally commits itself to providing however much liquidity the economy demands to prevent those rates from rising above the target. When the economy is strong, there is a natural tendency for interest rates to rise. Therefore, in order to prevent short-term interest rates from rising above its target when economic strength is keeping the demand for liquidity high, the Fed invariably will be forced to pump more liquidity into the economy to prevent the Fed funds rate from surpassing the target. The Fed is hoist on its own petard as it prevents liquidity growth from falling, contrary to its own directive.
While the Fed Chairman may be confused about what's going on, the country is better off for it. The central bank's operational error of creating more liquidity that it desires is having the beneficial effect of counteracting the misguided policy error it is striving to implement. Economic growth is not inflationary, and consequently there is not excessive liquidity in the system that should worry the Fed. Robust economic growth soaks up liquidity and dampens inflation.
Greenspan may be confused, but markets know precisely what they are doing, and this bodes well for the United States and world economies.