The Fed's wrong turn

March 25, 1994|By Robert Kuttner

ALAN Greenspan, the Federal Reserve chairman, is betting the health of the economy on a dubious theory. He thinks you can get long-term interest rates down by pushing short-term rates up.

The first time Mr. Greenspan tried the trick, it backfired. On Feb. 4, the Fed raised short-term rates a quarter-point, to 3.25 percent. Long-term rates quickly rose, by about half a point.

But rather than retreating, Mr. Greenspan concluded that his medicine hadn't been strong enough. This week, at the Tuesday meeting of its policy-setting Open Market Committee, the Fed hiked short-term rates another quarter-point, to 3.5 percent.

This time, long-term rates eased slightly -- for a day -- and then rose, portending tighter money across the board. In all likelihood, mortgages and other long-term borrowing costs will soon be stuck around 8 percent, more than a full point above last year's lows. And that cannot possibly be good for the economy.

Mark Twain once observed that a cat who sits down on a hot stove will never sit down on a cold one. In the 1970s, the economy genuinely overheated. As the decade ended, Paul Volcker's Fed reacted by pushing rates through the roof, to an agonizing peak of a 21.5 percent prime rate early in 1981.

After several years of austerity, inflation was painfully wrung out of the economy. But though inflation is no threat today, Mr.

Greenspan's Fed cannot look at a period of normal growth without imagining an inflationary boil.

The key economic indicators suggest an almost total absence of inflation. The rest of the world is still in recession. In an era of corporate downsizing and fierce international competition, American workers have no leverage to demand inflationary wage hikes.

The price of oil has been steadily declining. Despite a few months of heartening economic growth, the consumer price index lately has hardly budged.

Rather than looking at such economic fundamentals, the Fed is playing a bizarre expectations game. Supposedly, the money markets worry that faster economic growth will generate inflation some time in the near future. That, in turn, causes the bond market to demand higher rates of interest on long-term investments now, as insurance against future inflation.

The Fed has convinced itself that tightening money now, well in advance of actual inflation, will calm the markets. Supposedly once markets are reassured that the Fed will tolerate no inflation, long-term rates will stabilize.

But the Fed's logic is exactly backward. The main source of inflationary expectations in the money markets today is not the real economy, but the Fed itself.

Here's how it really works: The Fed tightens short-term rates. That may mean that the Fed knows something about inflation, or that the Fed is merely seeing ghosts. But in either case it portends higher rates. So the markets naturally bid up the interest that they charge.

The Fed's strategy creates a self-fulfilling prophesy. The Fed imagines inflation, raises rates and frightens the bond market. The Fed then concludes from the bond market's worries that it has to raise rates further.

Press accounts of Fed actions usually include a sentence dutifully explaining that the Fed can affect short-term rates but not long-term ones. This is simply the press parroting the party line. The Fed indeed influences long-term rates, though indirectly. At present, it is influencing them perversely.

Wall Street now expects the Fed to raise short-term rates at least another quarter point, and perhaps half a point, later this year. So we can expect this ratcheting-up of rates to continue.

What is at stake here, of course, is more than yields on bonds. When the Fed raises interest rates and the bond market follows suit, everyone's borrowing costs rise and economic recovery is choked off.

During the 17 months when the Fed allowed short-term rates to stay at 3 percent, we saw the power of cheap money: Homeowners refinanced loans; young families purchased homes; businesses restructured debts; unemployment eased down to just over 6 percent; and the recession finally ended.

In the last quarter of 1993, the economy briefly attained a growth rate of 7.5 percent. That sounds prodigious, but it is only normal for this phase of a recovery. In the first quarter of recovery from the 1981-83 recession, growth exceeded 9 percent.

Most economists think that the economy will grow at 3 percent to 3.5 percent in the first quarter of 1994, and slightly less later in the year. That is barely tolerable for an economy where corporations are continuing to shed jobs, where unemployment is stuck at over 6 percent, and where living standards are stagnant.

The Fed's strategy not only short-circuits the fledgling recovery; it is creating the tight money that Mr. Greenspan says he wants to avert. If he truly wants to reassure the markets and prolong the recovery, he should announce that short-term rates will stay put.

President Clinton will soon name two appointees to the Fed's seven-member board of governors. He would be wise to pick people with a different understanding of interest rates, inflation and prosperity.

Robert Kuttner writes a syndicated column on economic matters.

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