Alan Greenspan's conundrum

Jack Kemp
Posted: Jun 20, 2005 12:00 AM

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.

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.