By cutting short-term interest rates to their lowest levels in 39 years, the Federal Reserve should have been able to jump-start the nation's stalled economy. That medicine has worked well in the previous eight post-World War II recoveries. But these are not normal times and the normal remedies are not working.
The nation is experiencing a feeble recovery. Job creation has fallen off. Orders have not picked up and industrial production declined last month. There is fear of another dip again later this year.
Why hasn't the Fed's loose money policy of the past three years resulted in a spurt of economic activity? Economists say there are several explanations. The previous cuts in short-term rates generated a great deal of refinancing of old debt but very little investment in expanding existing production or starting new production. In addition, banks, which made loans with great abandon in the 1980s, are being extremely cautious this time around. Perhaps the most telling reason is that long-term interest rates are still too high.
Even though inflation has fallen to an annual rate of less than three percent, long-term interest rates have hardly budged in three years. As long as the gap between these rates and inflation continues to be so large, businesses will shy away from making investments in plants and equipment that could result in increased business activity.
Why are rates so high? Investors look at the continuing deficit and the refusal of Congress and the White House to reduce it. With Washington unwilling to face up to these deficits, lenders hedge against future inflation -- which means long-term rates stay high and discourage investment. In addition, lenders worry that Eastern Europe and the former Soviet republics will absorb large amounts of capital that used to flow to the United States.
The options available to revive the economy have diminished. If monetary policy isn't working, it leaves fiscal policy as the other remedy. But the old-fashioned Keynesian medicine of government spending is likely to increase the size of the national deficit, which in turn will create more pessimistic expectations about inflation. During this year's presidential campaign, the candidates have to lay out in great detail what they plan to do to accelerate the current anemic recovery. It won't be easy.