- The Washington Times - Saturday, October 22, 2005

Several of the wisest economists and editorial writers I know recommend the Federal Reserve keep raising interest rates until … until what? Until something bad happens?

Central banking is the last refuge of central planning — the notion a group of experts can meet secretly and plan the economy from the top down.

But this game has no rules. We speak of the “art of central banking,” as if it were like a magic show. So long as a central bank doesn’t mess up too badly, we tend to almost deify central bankers. When they mess up, many argue we must have deserved the suffering as penance for the good times.

One well-known problem with this magic show is called “recognition lag,” and it often results in “overshooting” — pushing interest rates too high or too low for too long.

Carefully look at the reasons given for Fed decisions and you find they always refer to some past event. Economic growth looked fine last year or last quarter, for example. This is like speeding on the highway while trying to steer by gazing in the rearview mirror — to see if you’re staying inside the lines.

For mysterious reasons, these speeding, backward-gazing magicians prefer focusing on past news about the real economy, rather than growth of inflation or nominal spending. The inference is that vigorous growth must be inflationary and weak growth ensures weak inflation. Yet inflation has always gone up whenever economic growth turned flat or negative — in 1974-75, 1979-81, 1990 and even 2001.

Nobody knows what the Fed will do next, or why. But I know what happened in the past under eerily similar circumstances. Every recession in the last 30 years has been preceded by a confluence of four events, three of them perhaps avoidable:

• First, energy prices rose rapidly before every recession. Within the consumer price index (CPI), energy prices rose 8.1 percent in 1973 and 29.6 percent in 1974; 25.1 percent in 1979 and 30.9 percent in 1980; 5.6 percent in 1989 and 8.3 percent in 1990; and 16.9 percent in 2000.

Aside from 2000, inflation in general was terribly high even before those energy price spikes — the nonenergy CPI rose 7.8 percent in 1978 and 4.4 percent in 1988. But after oil prices spiked, for a few years the nonenergy CPI always slowed rather than accelerated. There is no evidence energy price spikes ever increased nonenergy inflation. That’s a dangerous myth.

• Second, due to Fed tightening, the yield curve became flat (as in 2000) or inverted. The Fed pushed the fed funds rate above the yield on long-term Treasury bonds in 1969, 1973-74,1979-81 and 1989.

• Third, the fed funds rate was relatively high in real terms — at least 2 or 3 percentage points higher than inflation in the CPI less energy.

These same interest rate patterns work well in reverse. Before inflation accelerated, the yield curve steepened and the real fed funds rate was near zero or negative. The funds rate was well below bond yields in 1971-72, 1975-77, 1987-88 and 2003-2004. And the funds rate was equal to or lower than nonenergy CPI inflation in 1974-77, 1992-93 and 2003-2004.

This is not happening now. The opposite is true. If we compare the funds rate with long bond yields or nonenergy inflation, the Fed was indeed too easy in 2003-2004. But not this year. Advocates of several more fed funds rate increases seem to be steering with the rearview mirror.

Although I believe the Fed pushed the fed funds rate too low in 2003-2004, that does not require or justify overshooting in the other direction in 2006. If rates rise too much, the Fed might again overreact to the resulting recession by easing too aggressively long after the recession (as in 1992-93 and 2003-2004). To avoid lurching back and forth between brake and accelerator requires great caution and foresight. Rules would be better, but there are none. Monetary policy is a euphemism for whim and caprice.

• The fourth potentially troublesome development is that whenever energy prices and U.S. interest rates simultaneously rose in the past, foreign central banks turned it into a synchronized global squeeze by raising their interest rates, too. That copycat behavior was partly a result of confusing energy price spikes with a general inflation. The dollar was rising, as it this year, which makes dollar-based oil prices rise even faster in terms of sinking yen or euros.

“Banks from Japan to Europe ponder tightening With Fed,” notes a Page One headline in the Wall Street Journal. The writer’s only hope was that “a reversal in oil prices or renewed economic slump could put them on hold.”

That confirms my concern that central banks at home and abroad focus on the one relative price they can least control without precipitating recession — namely, the world oil price. A higher fed funds rate is a perverse way to persuade the Chinese to buy less oil or the Texans to produce more.

As for the ominously familiar idea that the largest central banks will push up rates until there is clear evidence of a “renewed economic slump,” that requires a trial-and-error process that can only end one way — in error. By definition, rates would keep rising until it’s too late.

The nonenergy CPI has averaged 2.2 percent since 1996 — compared with 5 percent from 1967 to 1995. On a year-to-year basis, nonenergy inflation was still 2.2 percent the last time I checked. It was even lower if you look at a more accurate chain-weighted index, and lower still in Japan and Europe.

The futures market has lately expected the U.S. fed funds rate to reach 4 percent early next year and keep heading higher. Unless something unexpected happens to lift the nonenergy CPI above its stubborn 2.2 percent trend, a 4 percent funds rate suggests a real interest rate on cash of about 2.3 percent.

It could be worse. The comparable real interest rate hit 3.5 percent in 1990 and 2000 before the economy began unraveling. Unless bond yields rise substantially, however, a funds rate of 4 percent or more would nonetheless be higher than the yield on 10-year Treasury bonds.

By this measure, the yield curve would be at best flat and probably inverted. That has never occurred amidst an energy price spike without the economy slipping into the tank. Never.

Alan Reynolds is a senior fellow with the Cato Institute and a nationally syndicated columnist.



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