The Fed's Faded Glory
By Martin Mayer, a guest scholar at the Brookings
Institution. His book, "The Fed," has just been published by the Free
Press.
If there is going to be "monetary policy," and almost everybody these days
agrees that there ought to be monetary policy, the hard question is the target
that policy should try to hit. There are three simple answers -- economic
activity (technically, gross domestic product), inflation, and employment. The
Federal Reserve system, which creates and enforces monetary policy in the
U.S., is enjoined by law to promote growth, eliminate inflation, and increase
employment, all at once. To achieve these goals, it has exactly one tool: It
can raise or lower the interest rate that financial institutions pay when they
borrow from each other overnight. It's hard to hit three targets with one
bullet, and easy to kill the wrong one.
A Theatrical Enterprise
Years ago, the Fed had much more to work with. William McChesney
Martin, as chairman of the Fed in the 1950s, could and did change the
reserves banks had to keep at the Fed, increase or reduce activity at the
"discount window" through which the Fed provided money for banks to lend,
change the "margin requirements" that determined how much credit was
available to stock market speculators, and set maximum interest rates banks
could pay for deposits at a time when the only way banks could increase
their total assets was by drawing new deposits or borrowing from each
other. And in those days lending by the banks provided about two-thirds of
the financing of American commerce and industry.
Banks' asset portfolios were stuffed with government bonds inherited from the budget deficits
of the World War II years, and the value of these bonds fluctuated according to the interest rates the Fed could control. By relatively small movements of the rates, Martin could keep inflation under control while forcing the Eisenhower administration to accept what John F. Kennedy in the 1960 election would deride as a "stop/go" economy.
And it was all done behind closed doors: The public did not know for six
months or more what decisions were made at the meetings of the Federal
Open Market Committee, and even after six months the revelations were
obscurely phrased to provide a minimum of information. What the Fed did
affected what the banks did, which affected what the real economy did,
which later affected prices in the stock market.
Former Fed governor Sherman Maisel reported that when President Richard
Nixon joked in the Oval Office about how he hoped for easier money from
Arthur Burns, whom he was swearing in as the new Fed chairman, all the
people from the Fed were "extremely uncomfortable," because they had
already given orders to their underlings to lower rates, and the underlings
were doing it, but nobody knew. Banks and Wall Street houses hired "Fed
watchers" to read the entrails.
Today, banks provide maybe one-fifth of the financing of American
commerce and industry, and they are armored against a Fed trying to control
them. "Reserve requirements" are meaningless, because most bank reserves
are "vault cash" in ATM machines that would have to be stocked anyway.
Banks get most of the money they lend by borrowing in the money markets,
and the discount window is inoperative, because banks are scared that if
they are seen borrowing from the Fed everyone will assume the market has
locked them out. Meanwhile, banks can buy or sell "derivatives" that enable
them to continue quite painlessly doing (or not doing) whatever it was the
Fed wanted them to stop (or do).
The Fed, in other words, has much less real power than it had a generation
ago. So it has become a highly theatrical enterprise, eager to seize attention
and create attitudes. Where once the puppet-master was behind the scenes
concealing the strings, the spin-master is now out front, announcing decisions
and reasons for them while the market is open -- sometimes, indeed, just
before the expiration of options and futures contracts, leveraging the
exposures of stock speculators for the purposes of the central bank.
The problem with all this is not the confusion of government and theater,
because governing is in many ways a theatrical art, but the absence of any
viable economic theory to explain why the Fed's jiggling with overnight
interest rates should have more than a marginal effect on economic activity.
Since January, the Fed has knocked 2.5 percentage points from the
overnight interest rate -- and looks likely to cut by another half point this
week -- but the yield on AAA-rated corporate bonds has actually risen by
about 0.25%, and it's the long rates that most affect investment planning.
From David Hume in 18th-century Scotland to John Maynard Keynes in the
1930s, it was assumed that if you put more "money" into an economy, people
felt richer and spent more, which stimulated growth. But it was also
assumed that if you raised interest rates you increased savings (people were
paid more to save) and if you lowered interest rates you reduced the
international value of your currency (by discouraging foreign investment).
Also that the later stages of an upswing in the economy reduced productivity
("diminishing returns") as you began to plow the less productive farmland
and hire the less efficient workers. None of this has been happening.
Monetary theory as a stepsister of general economic theory incorporated
and has retained many of these now false rules of thumb, inserting arbitrary
correctives as needed, and today the subject is a mess. Technological
change has deep-sixed the old monetary theories without floating a new one.
Laurence Meyer, who was in the forecasting business before he became a
Fed governor, said not long ago that the Fed's own models assumed that its
changes in interest rates were a "policy reaction" to developments in the real
economy, not the main drivers of anything. In his own models, he said, "real
interest rates are determined by forces of productivity and thrift" -- not by
the Federal Open Market Committee.
Three years ago, Alan Greenspan told a meeting in Washington that the Fed
had the best economists and mathematicians in the world, so its models were
the best in the world, "and the fact that they have been wrong for fourteen
straight quarters does not mean they will be wrong in the fifteenth quarter."
Graveyard Whistling
Because there is no viable theory, there is no way to predict whether the
next stimulus by the Fed will promote economic activity, increase the prices
of goods and services (the "cost of living") or raise the prices of assets (the
"stock market bubble"). Mr. Greenspan's Fed has been lucky: Massive
stimulation to pave over the problems of the 1990s went almost entirely into
asset prices. But inflation has been pushing 3.5%, a level at which Martin's
Fed went into crisis mode. Mr. Greenspan's repeated statements that
inflation isn't a worry have the sound of whistling past a graveyard,
especially because the tune harmonizes only with a decline in energy prices,
which may be many months away.
When oil prices jumped in 1973, the U.S. suffered a decade of stagflation --
low growth in national product and painful increase in prices. It could happen
again. Looking at monetary policy and what it does, Mr. Greenspan must
now consider whether the benefit of pushing the stock market up a little is
worth the growing risk that this time the Fed will be fueling inflation
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