In recent weeks too much emphasis has been placed by investors on the power of Federal Reserve policy. Does anybody really believe that a fractional change in the federal funds rate — from 1.25 percent to 1 percent — will trigger a buying panic for business loans? The Fed has been lowering the fed funds target rate since early 2001, yet there has been no pick up in commercial and industrial loans. As a matter of fact, the decline in interest rates has paralleled a fall in commercial and industrial loans at banks. Even though the federal budget has swung from a more-than $200 billion surplus to an estimated $400 billion deficit, interest rates are near 50-year lows.
In the old days when budget deficits were blamed for high interest rates, chairman Alan Greenspan would repeatedly tell Congress that there is no way interest rates could fall without a commensurate decline in the budget deficit. Even the new chairman of the Council of Economic Advisers, Gregory Mankiw, believes that budget deficits cause interest rates to rise. Yet, the budget deficit is soaring and interest rates are near 50-year lows.
The reason for these forecasting errors is that the Fed is panicking over deflation and plans to maintain low interest rates until the economy rebounds. Some members of the Fed threaten that they will go to a zero fed funds rate and, if necessary use other tools to get the economy going. Unfortunately, these brave commitments to easy money ignore the impact of easy money in Japan? The Japanese Central Bank (JCB) runs a zero interest-rate policy, has increased the monetary base by 35 percent, and still Japan has had no recovery. Is it any wonder why the Fed seems a little frenetic these days?
Media commentaries about impending deflation seem to have influenced the Fed to continue lowering interest rates. The intended purpose of lower interest rates is to increase liquidity that, in turn, stimulates economic activity. Yet, the ability to get liquidity into the financial system appears much more difficult than targeting interest rates. Rather than targeting interest rates, some economists believe that the Fed’s real power is controlling the monetary base. The base is defined as the total of bank reserves and currency in circulation. The theory stipulates that the Fed can buy and sell government securities and directly determine the level of bank reserves. This difference of opinion has important implications for those economists who advocate controlling interest rates vs. those who urge pumping reserves into the financial system to stimulate economic growth.
The problem is that neither policy has produced the intended effect — above-average growth in the economy. One might argue that, over the past year, the growth in the monetary base of 6.6 percent would appear to accommodate above-average economic growth. The reasonableness of this conclusion should be called into question when one examines the interim growth rates of the monetary base. For the three months ending March 19, 2003, the growth rate was 10.7 percent. For the two months ending April 16, the growth rate actually fell 0.5 percent and then, for the two months ending June 11, the growth rate jumped back into double digits to 11.4 percent, all at annual rates. If the Fed were so good at controlling the monetary base, these swings in monetary growth over shorter time periods should trigger some concerns over schizophrenia at the Fed.
Why would the Fed “pump” reserves at such wide growth rates over such short periods of time? It just doesn’t make sense, does it? One would think that Greenspan is controlling the monetary lever by shifting his weight side to side in the back seat of the car rather than by using the steering wheel. On the other hand, maybe the Fed can’t control the monetary base!
Think of the relationship between monetary policy and the economy as the same relationship between gasoline and an automobile. No matter how much gasoline (money) you put into the car’s gas tank, it will not influence how fast the car (the economy) will go. However, in order for the car to go faster, additional gasoline is needed. The causation goes from the economy to monetary policy and not the reverse; that’s why Fed watchers are a little paranoid about unexpected swings in the growth of “money.”
The challenge for Fed policy in the second half of 2003 will be accommodating the economic boom that will flow from aggressive fiscal stimulus. Once demand for loans begins to accelerate (the economic gas pedal), the related increase in reserves needed to support those loans may balloon the monetary base and pressure the Fed to move toward higher, not lower interest rates. The stories the Fed will tell over controlling the economy through monetary policy will make for more interesting reading than Harry Potter’s latest adventures.
— Tom Nugent is Executive Vice President & Chief Investment Officer of PlanMember Advisors, Inc., and an investment consultant for Wealth Management Services of South Carolina.