- The Washington Times - Monday, July 2, 2001

On Wednesday, the Federal Reserve cut interest rates by another quarter percentage point to 3.75 percent. When the Fed does this, as it has done five previous times this year, it is said that it is easing monetary policy, which will stimulate economic growth. However, there are growing doubts among economists that monetary policy has really eased, despite the rate cuts. If this is the case, growth will continue to lag for several more months, rather than rebounding as the Fed expects.

Easier money should lead to faster economic growth. As more money becomes available, consumers spend more and businesses will increase investment, thus stimulating growth. However, there has been little evidence of a pickup in business activity since the Fed first cut interest rates in January. This is leading some economists to question whether its policy of targeting interest rates is really the right way for the Fed to conduct monetary policy.

Although the press talks about the Fed cutting interest rates the same way it might report that General Motors has cut the price of one of its cars, the analogy is not correct. If GM lowers its price, it will sell more cars and eventually raise production. The Fed really does it the other way around. It increases the supply of liquidity in order to bring about a reduction in interest rates.

Moreover, the Fed doesn't really control interest rates; it controls one specific rate, called the federal funds rate. This is a rate banks charge each other on money loaned for just a single day. So it is not a rate at which any consumer can borrow. But because it represents the basic cost of funds to banks, it is assumed that other rates, such as the prime rate, will ultimately fall when the fed funds rate declines.

Not too many years ago, the Fed didn't even indicate when it had made a change in monetary policy. Banks had to employ "Fed watchers," whose job was to carefully monitor every action the Fed took in financial markets in order to figure out whether it had changed policy or not. To make their job even harder, the Fed would often deliberately obfuscate its actions.

The Fed conducts monetary policy principally by buying and selling U.S. Treasury securities. When it buys Treasury bills, notes and bonds, it adds liquidity to the financial system by literally creating the money to pay for its purchase. If it wishes to reduce liquidity, it does the reverse and sells securities from its portfolio.

As of June 20, the Fed owned $533 billion in Treasury securities, an increase of $1.8 billion over the previous week and $17 billion since the end of last year. But this doesn't necessarily tell us that the financial system has become more liquid.

The reason is that most of the money in our economy is actually created by banks. When you deposit $1 in your account, the bank lends 97 cents back out again, keeping the rest in reserve. Whoever gets that 97 cents may then deposit it in another bank, which will lend out 94 cents of the original $1, and so on. Of course, when people make withdrawals, the reverse process takes place.

The point is that the money supply is determined more by individual and business decisions than by what the Fed does. That is one reason why the money supply is an unreliable indicator of Fed policy.

Now, some critics say that interest rates are not a reliable indicator, either. They say that lower interest rates have, in effect, been imposed by Fed fiat, without an accompanying increase in liquidity. They point to the continuing weakness in commodity prices (even energy prices are starting to crack), the strength of the dollar on foreign exchange markets, falling investment and stock prices, and other signs that money is still tight.

Former vice presidential candidate Jack Kemp has suggested that instead of targeting interest rates, the Fed should target gold. He believes the price of gold is like a thermometer that more accurately measures monetary ease or tightness. Too much liquidity will raise fears of inflation, causing gold to rise, while too little liquidity is deflationary, causing gold to fall.

Although gold is up from its April low of $256 per ounce, it is still down from this time last year. Mr. Kemp thinks the Fed should continue to add liquidity, regardless of what happens to interest rates, until gold rises from its current level of $272 to about $300.

The Fed is not likely to adopt the Kemp plan, but it should continue easing monetary policy until some signs of inflation appear on the horizon. Right now, there are none.



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