The Fed's Long-Term Strategy

March 24, 1994

When the Federal Reserve Board boosts short-term interest rates, as it has done twice since early February, long-term interest rates are supposed to fall as investors' fears of inflation wane. Such Fed tinkering with short-term rates, which it controls, is designed mainly to influence long-term rates, which it does not. But as everyone knows, financial markets do not always behave as expected.

When the Fed nudged up the rates for overnight bank barrowing to 3 1/4 percent from 3 percent on Feb. 4, we suspect managers of the nation's bank were confounded when long-term rates went up, not down. Confounded and unhappy. Because a rise in long-term rates reflects an expectation of future high inflation, which is precisely what Fed chairman Alan Greenspan is forever fighting.

Critics of Mr. Greenspan, especially Democratic legislators facing elections this fall, feared the higher short-term rates would slow the economy, which had roared along at a 7.5 percent growth rate in 1993's final quarter, and possibly abort the recovery. Ever the advocates of easy money, they complained that the Fed had failed to anticipate that the two sets of interest rates sometimes move in parallel.

Their logic was simple -- and wrong. The more persuasive theoretical argument is that the markets felt the Fed was being too modest, that it was failing to take decisive enough action to head off the inflation bogey. And the more persuasive technical argument was that the spurt in long-term rates was due to market developments that were unrelated to the Fed's moves.

Whatever the arguments, the Fed seems rightly determined to stay the course. Its quarter-point raise this week is but the second of several ratchet steps that are likely to raise the federal funds rate to 4 percent or more in coming months. It promptly produced the effect the Feb. 4 move did not: Interest rates on long-term Treasury 30-year bonds fell steeply -- from 6.95 percent to 6.85 percent on Tuesday -- and the stock market signaled its satisfaction with the move.

Throughout this process, President Clinton has consistently abstained from criticism of the Fed's moves. Why? Not because he welcomes higher short-term rates, which politicians never do, but because lower long-term rates may serve to prolong a slow, steady recovery clear to the Clinton re-election year, 1996. In other words, he is willing to go along with Mr. Greenspan's theory that a "pre-emptive strike" now against inflation will help the economy in the long run. We do more than go along with the Fed chairman. We support him.

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