- The Washington Times - Monday, December 17, 2001

On Dec. 11, the Federal Reserve announced its 11th interest-rate cut this year, bringing the federal funds rate down to 1.75 percent, its low-

est level since 1961. Since there is obviously little room left to lower rates further, the consensus view among economists is that there is at most one rate cut left in the Fed's arsenal.

With end of Fed easing now in sight, some Bush administration economists are already asking when the next cycle of Fed tightening will begin? Given that the time lag between episodes of monetary tightening and easing have been very short in recent years, their concerns are not unjustified.

The Fed's penultimate period of easing came in 1998, the last rate reduction coming on Nov. 17. But just 225 days later, on June 30, 1999, the Fed was already starting to raise interest rates again. The previous cycle followed a similar pattern. The last rate reduction came on Jan. 31, 1996, and the next rate increase arrived just 419 days later on March 25.

What this means, in stark political terms, is that the odds of a Fed tightening between now and Election Day 2004 are virtually 100 percent. And it may come sooner, rather than later. Since 1986, there has been an average of 269 days between the end of a Fed easing episode and the beginning of a new round of tightening. Assuming there is one last rate cut at the Fed's next meeting on Jan. 29, the first rate increase could easily come at the Fed meeting scheduled for Nov. 6, 2002, just one day after Election Day.

With the probability that there will no Fed tightening before Election Day, House and Senate Republicans running for re-election can probably rest easy for now. But George W. Bush could have a serious problem. The Fed's last tightening episode lasted nine months from first to last rate increase. The previous two episodes lasted 13 months and 12 months, respectively.

Thus, assuming a new round of Fed tightening late next year or early in 2003, it will probably continue well into the presidential election cycle. If history holds, the Fed will not finish tightening monetary policy until early 2004. At a minimum, this probably means that the stock market will be weak in 2004, with slowing economic growth throughout the year. Not good news for President Bush.

It may seem absurd to be discussing Fed tightening at a time when the economy is in recession, unemployment is rising and deflation, rather than inflation, appears to be the bigger problem. Yet given the Fed's history and its well-known biases, it would be foolish to think that it will refrain from tightening monetary policy until after Election Day 2004.

The most important thing to know about the Fed that is relevant to this discussion is that it firmly believes, as an institution, that economic growth, per se, is inflationary. It says so in every monetary statement it makes. As Cato Institute economist Alan Reynolds points out, the Fed says economic weakness is what justifies its rate reductions, so obviously economic growth must be what justifies monetary tightening. Economists call this the Phillips Curve trade-off higher growth stimulates inflation, slow growth causes inflation to fall.

Many economists, however, believe that growth doesn't have anything to do with inflation. How can producing more goods and services be inflationary, they ask, when inflation is fundamentally caused by too much money chasing too few goods? Increasing output per man hour is, in fact, deflationary.

Nevertheless, the Fed has always believed that its job is to take away the punch bowl just when the party starts to get good, as former Fed Chairman William McChesney Martin once put it. And as an independent agency, it can do so no matter what any White House thinks. George Bush's father found this out the hard way, when the Fed tightened throughout 1988 and into 1989, virtually guaranteeing slow growth going into 1992, given the lag between monetary actions and their impact on the economy.

What the current President Bush can do to avoid his father's fate is hard to say. He would have helped himself a lot by appointing governors to the Federal Reserve Board who reject the Phillips Curve tradeoff. However, those he has appointed Susan Schmidt Bies and Mark Olson appear to be get along/go along-types who are not going to rock the boat.

But Mr. Bush already has two more opportunities to put his own people on the seven-member Federal Reserve Board. Fed Govs. Edward Kelly and Laurence Meyer will both leave shortly. Mr. Bush's re-election hopes may ride on whom he appoints to fill these critical slots.

Unless he appoints people who reject the Phillips Curve and will argue the point strenuously, the Fed may do to him what it did to his father.

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