Federal Research may be moving too slow

Posted: Aug 17, 2001 12:00 AM
The Federal Open Market Committee (FOMC) of the Federal Reserve meets Aug. 21 to set monetary policy and interest rates. It is widely expected that the FOMC will again cut the federal funds interest rate by another one-quarter percentage point, bringing it down to 3.5 percent. This key interest rate was 6.5 percent a year ago. The FOMC meets amid growing criticism that it has been too slow to ease monetary policy, thus causing the economy to slow and unemployment to rise unnecessarily. The Fed's response is that monetary policy affects the economy only with a lag, and that it would be irresponsible to change monetary policy too aggressively. As with an automobile, mistakes are more easily corrected at slow speeds and dangers are greatest at high speeds. The Fed also argues that monetary policy is not the only factor affecting the economy, and it would be unwise to use monetary policy to correct problems not caused by monetary factors. It might be unwise as well to have a too-aggressive monetary expansion when fiscal policy, in the form of the tax rebate, is also expansive. Lastly, although the economy has clearly slowed, the slowdown is not broadly based. Consumers, for example, have been largely unaffected by the slowdown, which has mainly been caused by inventory liquidation and a sharp decline in capital investment. In a recent analysis, economist Charles Kadlec of J. & W. Seligman in New York says that we may be closer to the bottom of the slowdown than most people think. It is always darkest just before dawn, so it is said, and the release of economic and financial data always lags behind reality. So the fact that all of the recent data, especially corporate profits, have been negative is no reason to assume that the downward trend will continue indefinitely. Kadlec's key point is that monetary policy has not been as expansive as the Fed and financial markets think. The Fed first lowered interest rates on Jan. 3. Given the lags, many economists would have expected to see some impact by now. In theory, lower interest rates lead to monetary expansion because they lower the cost of holding cash, and because the Fed must add liquidity to the financial system in order to achieve its interest rate target. The problem is, as Kadlec explains, that market interest rates were well above the Fed funds rate when the Fed first acted in January. Market rates also fell as the Fed was acting. The result is that the Fed's easing did not really become effective until May -- five months later than most analysts assume. It is important to understand that the Fed does not control all interest rates, just one special rate. The Fed funds rate is the interest rate banks charge each other and represents the basic cost of funds for banks to lend out. The spread between the Fed funds rate and what banks charge borrowers is the bank's profit. At the beginning of the year, this spread was negative. The Fed funds rate was well above many market interest rates. In January, the fed funds rate averaged almost 6 percent, while the Treasury's 30-year bond was just 5.5 percent. All bonds with shorter maturities had even lower rates. This meant that banks could not borrow fed funds and re-lend them at a profit. As a result, monetary policy was impotent. Economists call this "pushing on a string." But by May the situation had turned around. The average Fed funds rate fell to 4.2 percent and for the first time in over a year was now lower than the Treasury's two-year note rate. It was at this point that monetary policy finally became expansive, a fact confirmed by growth of the money supply since that date. During June and July, the spread between Fed funds and market rates widened. As banks can now lend profitably, it provides a transmission mechanism through which liquidity can expand throughout the economy. Kadlec further notes that because the economic slowdown is so narrowly concentrated in inventories and investment, it won't take much to turn the economy around quickly. Falling inventories and investment subtracted 2.7 percent from second-quarter GDP growth. Thus, if investment and inventories just stop falling and stabilize, growth could rebound to more than 3 percent almost overnight. When firms begin to expand inventories and investment, growth will be even faster. It is true that signs of recovery are now sparse. But as expanding liquidity continues to spread throughout the financial sector, eventually it will begin to affect the real economy. By the fourth quarter, meaningful signs of economic expansion should be evident. Note: The Kadlec commentary may be found at: www.seligman.com/about/eco/eco010806.htm