Fedspeak about sustainable growth

Posted: Jun 26, 2003 12:00 AM

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.

Perhaps the FOMC meant to say that a broad-based decline in prices (deflation) would be unwelcome. But that is not what it said. What it said was that lower inflation would be unwelcome. For the year ending in May, the broad deflator for personal consumption was up 2.3 percent and the CPI was up 2.1 percent. Excluding food and energy cuts that to 1.6 percent. Would it really be so unwelcome if inflation fell to 1 percent, as it has in China?

The FOMC says the risk of substantially lower inflation is "minor," yet it says that minor risk is nonetheless greater than the risk of higher inflation. Since substantially lower inflation is unwelcome, that seems to suggest it might welcome higher inflation. Yet the FOMC went on to say that "the latter concern" (about a pickup in inflation) "is likely to predominate for the foreseeable future." For the foreseeable future, the Fed is more likely to be concerned about a pickup in inflation, but for the moment it is more concerned about a "minor" risk of lower inflation.

All the big monetary policy questions come down to what targets the Fed should aim at and what instruments it should use to hit those targets. The Fed is sometimes criticized for treating interest rates as a target, but that is not quite fair. When the Fed says it will now keep the fed funds rate close to 1 percent, that means it will buy more Treasury bills whenever that rate tends to move above that level. The Fed pays for those T-bills by writing a check on itself. Those checks end up being credited to some banks' reserves at the Fed. With more reserves, banks can make more loans or buy more securities, putting new money into checking accounts (which require the extra reserves).

The distinction some draw between lowering the fed funds target and providing more liquidity (bank reserves) is normally misleading. The only way the Fed can keep interest rates on bank reserves lower than before is to provide more reserves to the banking system, most often by monetizing more federal debt.

It is sometimes said the Fed can only affect short-term interest rates, not long-term rates. That, too, is usually misleading. Long rates almost always move in the same direction as short rates, although not as much. If the Fed tries to keep short rates too low for too long, however, the market will gradually sense that this is an unsustainable policy and widen the spread between short and long rates.

The Fed now tries to target some mix of "sustainable" real growth and "welcome" inflation mostly by using information about the real economy (it rarely mentions prices) that is inherently backward-looking. Trying to fine-tune the economy's past performance has often contributed to instability, partly because even schoolchildren can figure out the Fed's game. Because consumers and firms rightly expected the Fed to keep pushing interest rates lower so long as the economy looked sluggish, for example, it made sense to postpone interest-sensitive purchases until rates seemed to have bottomed. And it will likewise make perverse sense, given the Fed's lagged reactions, to rush to borrow and spend after rates begin heading up.

Another problem with reducing the fed funds rate because of a perception that past economic growth has been inadequate is that it virtually invites the Fed to raise the fed funds rate after growth improves, even if inflation remains very low.

The Fed has given itself too many chores over the years, which makes it less likely that it will do any of them very well. It is up to Congress, not the Fed, to reduce tax and regulatory obstacles to economic growth. That will make the Fed's job easier because additional supply, innovation and productivity help to hold inflation down, contrary to Fed dogma. It is also up to Congress to give the Fed a clear assignment -- to keep some acceptable measure of inflation within a narrow range.

When Fed officials start fretting about lower inflation being unwelcome and assigning itself the arrogant task of creating "sustainable" economic growth, it is clear it cannot be trusted to even make sensible statements, much less sensible policy.