On Jan. 3, the Federal Reserve took an essential first step toward staving off a recession by cutting the federal funds interest rate from 6.5 percent to 6 percent. When the Fed last acted on May 16, raising the rate from 6 percent to 6.5 percent, many economists said that it had tightened monetary policy one notch too far. Now the chickens have come home to roost, and Fed Chairman Alan Greenspan is desperately trying protect his reputation as the economy's "maestro." It may be too late.
In many years of observing Federal Reserve policy, I have been amazed to see it consistently make the same mistake over and over again. That is to conduct monetary policy as if there are no lags. In other words, to act as if its actions affect the economy instantaneously. In fact, as all economists know, including those at the Fed, monetary policy takes time to influence the real economy. Although the lag is not exact, most economists would say that the ultimate impact of a Fed action to tighten or ease will come 9-12 months later.
Why does the Fed act as if there are no lags, when it clearly knows better? A lot of it has to do with the cloistered environment within which the Fed operates. It conducts its deliberations in secret and is largely unaccountable either to the president or Congress. The purpose is to insulate monetary policy from political pressure, which is good, but it also leads to detachment and perhaps an overinflated sense of what the Fed can and cannot do.
This last factor is encouraged by the cult of "Fed-watching." There is a whole industry of people who devote themselves almost exclusively to observing and interpreting every indicator that might give the slightest hint as to what the Fed will do next and when. The reason is because the stakes are enormous. When the Fed announced its rate cut last week, for example, the Dow Jones Industrial Average instantaneously jumped more than 300 points. Any investor with even a few minutes of advance warning of the Fed's action could have made millions very quickly.
Of course, the Fed does everything possible to keep its actions secret, precisely to avoid giving any investor an unfair advantage. But this does not discourage people from doing everything from reading tea leaves to measuring the thickness of Greenspan's brief case as he goes into board meetings. (The theory is that if his briefcase is bulging with papers, the Fed is more likely to act.)
Moreover, the nature of monetary policy makes it inherently confusing and difficult to interpret. This problem is compounded by changes in the economy and in Fed operating procedures. For example, there was a time when the Fed was very concerned about the money supply, and economists used to study the money supply figures with deep intensity. But changes in the financial system and the Fed's philosophy have relegated the once all-important money supply figures to the academic backwaters.
In recent years, the Fed seems to have operated primarily according to something called the Phillips Curve, which shows that low unemployment is associated with high inflation. Thus, as the unemployment rate fell to historically low levels, the Fed became increasingly concerned that low unemployment would cause inflation to rise.
The Fed has also expressed concern about something called the wealth effect. This theory says that as the stock market rises and people become wealthier, they go out and spend more. Since in the short-run, the supply of goods and services is relatively fixed, this wealth-driven increase in demand causes prices to rise.
Thus, the fall in unemployment and the rise in the stock market both drove the Fed to tighten monetary policy and raise interest rates beginning in June 1999. Not surprisingly, the stock market peaked almost exactly nine months later, as the lagged effect of the Fed's tightening took hold. The Fed continued tightening through May 2000. Given the lags, this suggests that the depressing effect of the Fed's previous tightening will not have fully worked its way through the economy for another several months, despite last week's easing.
Although the market reacted positively to this initial Fed rate cut, it knows that many more cuts are needed and will be coming over future months. I expect it will not be before the end of the year that the fed funds rate is back down to where it was before the Fed began its latest round of tightening. We can probably expect 4-5 rounds of quarter-point interest rate cuts at roughly six-week intervals for the rest of the year.
The problem is that even if the Fed eases with uncharacteristic aggressiveness, the U.S. economy inevitably is in for several months of anemic growth resulting from past tightening. Also, the Fed's policy of dribbling out rate cuts a little at a time means that the ultimate benefits won't occur until late next year. Indeed, the Fed's policy actually inhibits the beneficial effects of easing from taking effect, because investors have an incentive to wait until interest rates have bottomed before acting.
The Fed was moved to act by an unexpectedly low statistic from the National Association of Purchasing Managers. Their index has been below 50 for 5 months in a row, which indicates a contraction in the manufacturing sector. The 43.7 percent figure registered in December is the lowest since the recession year of 1991. We can expect further negative economic indicators in the months to come before the Fed's initial round of easing takes hold.