What's the Fed up to?

May 23, 1994|By Robert Kuttner

THE Federal Reserve has now raised interest rates four times in as many months. Short term rates have gone from 3 percent to 4.25. The prime rate has gone from 6 percent to 7.25. Mortgages are now close to 9 percent.

This will of course slow economic growth -- which is just what the Fed intended. It will become more expensive for consumers to buy a home or finance a car. And the higher cost of capital will also deter business investment.

On the very eve of this latest rate hike, government statistics once again showed that the Fed is mistaken about inflationary pressures.

The consumer price index for April rose just one-tenth of one percent, and the core inflation level actually fell. What, then, is the Fed really up to?

An oft-heard explanation is that the Fed is trying to compensate for the irrationality of money markets. There may be no inflationary pressures now, but if money markets think inflation is around the corner they will bid up interest rates anyway.

Thus a prudent dose of tighter money now can supposedly head off worse rate hikes later on, by assuring markets that the Fed will be vigilant against inflation. There is one thing wrong with this theory. The markets were happily committing long-term money at about 6 percent interest, before the Fed acted.

They obviously had no expectation of inflation. It was the Fed's own action, and not market anxieties, that precipitated today's higher rates.

A second popular theory holds that the Fed's timing had something to do with the "political business cycle" -- the sensitivity of the Fed to the election calendar. Chairman Greenspan and President Clinton meet regularly, and are said to have a cordial relationship. It is possible that Mr. Greenspan may have signaled the president that rates would have to rise at some point, and better to get the rate hike out of the way now, rather than to roil the markets on the eve of the 1994 election (or, worse, the 1996 presidential election).

There may be something to this. But that presumes the rate hike was necessary at all. Both the National Association of Manufacturers and the U.S. Chamber of Commerce, friends neither of Mr. Clinton nor of inflationary monetary policy, criticize the Fed for imagining inflation.

Likewise, the administration's own economists, though declining to criticize the Fed publicly, find neither wage inflation nor price inflation.

The consensus within the administration is that unemployment could come down to roughly 5.5 percent (it is now 6.4 percent) before inflation becomes a concern.

Privately, administration economists think the economy could grow at something close to 3.5 percent without kindling inflation. To allow growth to fall below that frontier is to tolerate higher than necessary unemployment.

The Fed seems to be targeting a growth rate of just 2.5 percent. The difference between 2.5 percent growth and 3.5 percent growth may not seem much. But it is the difference between steadily rising living standards and stagnant ones.

A third possibility is that the Fed acted, in part, to defend the U.S. dollar.

There are reports from Frankfurt that Germany's powerful central bank, the Bundesbank, has an implicit deal with Mr. Greenspan to shore up the dollar by letting German rates subside while American ones rise. This also has the virtue of stimulating German growth, in a German election year.

Treasury Secretary Lloyd Bentsen until recently sought to "talk down" the value of the dollar as a way of making American products more competitive in world markets. But Mr. Bentsen overreached and the dollar began going into free fall, requiring the Fed to rescue the dollar with higher interest rates.

There may be some truth to each of these theories, but there is a more fundamental explanation. The Fed chronically panders to the concerns of the money markets that are its prime constituency. It has a congenital bias in favor of slow growth and absolute price stability, because this guarantees that bonds will hold their value and hence soothes creditors.

The Fed is supposed to be a committee of wise elders, largely immune to political pressure and motivated by what is good for the economy. But such bodies are seldom truly above politics. The politics, in this case the Fed's deference to Wall Street, are simply more opaque. Nor are such bodies of experts immune to error. Their political slant merely influences the kind of error they make.

Mr. Greenspan did one thing right at the May 17 Fed meeting where he announced the latest rate hike. He hinted that he will now leave rates alone for awhile. It's too bad he didn't decide that back in February, before the Fed needlessly sandbagged growth. One hopes that Mr. Clinton's two new appointees to the Fed will make a constructive difference.

Robert Kuttner writes a column on economic matters.

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