- The Washington Times - Tuesday, August 21, 2001

The Fed meets again today to contemplate what to do about interest rates and bank reserves. The right answer depends on what target they are trying to hit.
We have been led to believe the Fed raises interest rates on bank reserves when inflation accelerates, then lowers them when inflation abates.
Comparing the fed funds rate with a "core" version of the Fed's favorite measure of inflation, the deflator for personal consumption, makes you wonder. Using that inflation gauge, the Fed's interest rate moves appear mysterious, unrelated to changes in inflation. The funds rate was above 4 percent during the second quarter, for example, even though core inflation was barely more than 1 percent and growth of real GDP will likely be revised below zero. By contrast, the Fed held the funds rate below 3 1/4 percent from July 1992 to February 1994 — at a time when core inflation was much higher than it is today and the real economy was expanding by about 3 percent a year.
Changes in the fed funds rate would be incomprehensible even if energy were put back into the index. The Fed did ease in late 1998 when energy prices fell, then tightened a year later when energy rose, but one hopes that does not mean the Fed was obsessing over energy while the rest of the CPI slowed.
Energy prices often gyrate with global events having nothing to do with U.S. monetary policy. Oil prices fell in 1998 because of the Asian crisis, not because the Fed was tight. The worst possible Fed policy would be to raise interest rates when energy prices go up (as happened in 1989-1990 and 1999-2000), but then switch to focusing on core inflation when energy prices go down (as is happening right now). With food and energy included, the CPI and PPI both fell sharply in July, so the broadest price indexes make it look even less necessary to keep interest rates higher than in 1992-93.
Are there any other signs of inflation that ought to discourage the Fed from putting the funds rate back to 3 percent? Commodity prices have fallen all year and bond yields are near a record low — scarcely symptoms of imminent inflation. The dollar rose while the Fed was bringing rates down, so the dollar's recent dip does not mean high interest rates (and low stock prices) attract world capital.
The monetary base in July was up a modest 5.3 percent from a year ago. And the funds rate has remained higher than the growth of nominal GDP for the past four quarters, which is another indicator of tight policy.
Many argue that Chairman Alan Greenspan's Federal Reserve should be aiming at the real economy rather than inflation, easing until there are clear signs of recovery. Yet trying to fine-tune the real economy helped get us into this slump, and is unlikely to help get us out. Perpetually optimistic forecasters can repeatedly predict that recovery is right around the corner, allowing them to assert (by assuming real growth is the objective) that the Fed has done enough.
The real problem with Fed gradualism has nothing to do with forecasting or fine-tuning. A fed funds rate that remains close to 4 percent is simply higher than necessary to keep inflation at bay. If and when that ceases to be the case, the Fed can and should put interest rates back up, as it did in 1994.
It is now widely anticipated that the fed funds rate will eventually drop to 3 percent or less, if only because the Fed set the rate at 3 percent a decade ago, when inflation and real growth were much higher. But forecasters also assume the Fed will take its time getting to 3 percent, through a series of grudging quarter-point cuts. If that happens, anyone contemplating making interest-sensitive investments will have a perverse incentive to wait until rates drop further.
A fed funds rate of 3 percent in 1993 helped that recovery without fostering higher inflation. If 3 percent made sense in 1993, it makes much better sense today.

Alan Reynolds is a senior fellow with the Cato Institute.


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