In Doing Nothing, Fed Did a World of Good

The Federal Reserve Board did good last week--by doing nothing. But the issue of raising interest rates will come back again, perhaps by the next Federal Open Market Committee meeting five weeks from now. It is important to understand why the Fed was right now and why it will be right in the future if it refrains from rocking the markets--and the economy.

It is not merely that higher interest rates increase the burden on millions of Americans--in higher borrowing costs on the purchase of homes and on home equity loans, on the purchase of cars and other durable goods, and in financing college educations. It is, rather, that if they are effective, they can only be so by slowing the economy and increasing unemployment. The costs of that to most of us can be enormous.

Raising interest rates is supposed to be a measure to combat inflation. There are serious problems with this argument. For one thing, interest payments are a cost of doing business. To some extent, higher interest rates will be passed on in higher prices. More fundamentally, the Federal Reserve does not have the tools to target prices or inflation alone. What it can do is hold down private spending--for those new houses, automobiles and business investment. Will this lead sellers to hold down prices--or hold down orders and reduce output in the face of reduced demand? The evidence shows they may do some of each.

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There are good arguments from conservatives and liberals alike against this kind of “fine-tuning” by the Fed. Conservative economist and Nobel Laureate Milton Friedman has long urged that the monetary authority stick to some simple rule, like letting bank reserves or some measure of the money supply grow at a constant rate and letting market interest rates adjust. He points out that, given the delays in the effects from Fed action--probably a year or more--and our difficulties in making accurate forecasts, Fed actions may well prove perverse. If, thinking the economy is doing “too well,” the central bank raises interest rates now, the effects in slowing the economy may not be felt until the boom is past and activity is slowing anyway. A pause may thus be turned into a recession, a mild recession into a sharp decline.

The great economist John Maynard Keynes argued against trying to stabilize the economy by lopping off booms. He urged instead policies to fill in the troughs or recessions. Important for this and for higher employment and more rapid growth were lower interest rates. Keynes complained six decades ago that central banks were not aggressively pursuing those lower rates.

The costs of not consistently pursuing lower rates are more than short-run.

Each time the Fed raises short-term interest rates by raising its target federal funds rate--that banks have to pay to get reserves--it raises investor expectations that it may do this again, whenever it thinks the economy is doing briskly. Since long-term interest rates are a weighted average, adjusted for risk, of expected short-term rates, these expectations, whatever happens to inflation, keep real long-term rates higher than they would be otherwise. And these higher real rates--the actual rates adjusted for inflation--mean less investment, slower growth and more unemployment.

Unfortunately, propelling many to advocate slowing the economy is the dreadful dogma of the NAIRU, the non-accelerating inflation rate of unemployment, which asserts that if unemployment gets below that magic rate, long held to be at 6% or higher, inflation would not only increase but keep increasing indefinitely, to astronomical heights.

I have long challenged this, and found that in the last 40 years of our history, though higher unemployment may have lowered inflation, lower unemployment, for a variety of reasons, did not increase it. Events of the last three years have amply confirmed my econometric studies. Unemployment has been steadily below that 6%--down to 4.9% in April--with no evidence whatsoever of accelerating inflation. Inflation, if anything, is down.

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While the Fed has appeared sympathetic to NAIRU dogma--and some members apparently still are--Fed Chairman Alan Greenspan has made it clear that he is skeptical and pragmatic. He is more interested in looking at the actual numbers on inflation than anybody’s computer projections.

For that we should certainly be thankful. Each percentage point we lose in economic growth costs us $75 billion in gross domestic product in one year, some $150 billion in the second year and $225 billion in the third. One percentage point more of unemployment means a short-term loss of about $150 billion in output.

The losses now--for education, for health, for infrastructure and for private consumption--are huge. And so are our losses in investment in the future, in all kinds of capital, public and private, tangible and intangible.

So praise the Fed indeed--this time, at least.