The Fed's Diminishing Clout

By Christopher Farrell Right now, all eyes are on the Federal Reserve Board. Despite slashing rates by 39% so far this year, the economy is showing few signs of the long-anticipated revival. Yes, consumers are hanging in there. But recent government statistics still show a stagnant economy during April and May.

The outlook overseas is deteriorating, with Japan mired in recession and European growth slowing as exports decline. Wall Street widely expects another rate cut at the Fed's next policymaking meeting on June 27. A Bloomberg News survey from June 19 has eight of the 25 bond dealers who trade directly with the Fed anticipating another half-point cut -- nearly triple the number at the start of the month.

It's still anyone's guess when the Fed rate cuts will start resuscitating the economy, especially since monetary policy typically operates with a lag of 6 months to 18 months. But it's not too early to start assessing how well the Fed has conducted monetary policy in recent years. After all, the Fed hiked its benchmark interest rates six times beginning in 1999 to slow down a red-hot economy, only to reduce the fed funds rate five times so far this year -- with more to come -- to stave off recession.

THE FRIEDMAN SCHOOL. Are these frequent shifts in short-term interest rates a sensible way to run a central bank and influence an economy? The answer would seem to be a resounding yes by the standards of the past half-century. Milton Friedman, the dean of monetary economists, long ago postulated, correctly, that the Fed showed a tendency to react far too slowly to signs that inflation was stirring. In the decades after World War II, the Fed repeatedly would hike rates to dampen inflation pressures long after inflation was out of the barn. The economy would subsequently sink into recession.

That's not a problem anymore. Today, the Fed has absorbed Friedman's insights -- some critics would say with a vengeance. To be sure, Friedman's solution was that the Fed should more tightly control the money supply, rather than manipulate short-term rates. But the central bank has largely ignored that notion since no one knows exactly what money is in a credit-soaked economy.

Instead, the Fed under Greenspan has changed rates far more frequently than in the past. "The key is that monetary policy has to be preemptive," says Frederic Mishkin, a leading central bank scholar at Columbia University. Adds Benjamin Friedman, economist at Harvard University: "Some people say, what if the Fed lowers rates once again and it goes too far and it has to turn around and raise rates next year? My response is, 'What's wrong with that?'"

OPEN ATTITUDE. Academics also laud the central bank under Greenspan for operating in a more open manner than in the past. For instance, interest-rate decisions by the Federal Open Market Committee, the policymaking meeting held eight times a year, used to be cloaked in secrecy. Now, the FOMC policy judgment is disseminated immediately to the financial markets.

Still, many Fed watchers are troubled over how the board should adjust to a global economy. Is the preemptive strike still the right policy stance for a global capital market? Or, considering the dismal track record of macroeconomic forecasters, is it too difficult a task for the Fed to consistently steer the economy?

There are many reform proposals gaining a serious hearing these days. For example, a number of academic economists argue the Fed should establish strict inflation targets and then put monetary policy on near-autopilot. In his new book, The Fed, long-time financial journalist Martin Mayer favors targeting asset values, with more than 50% of all U.S. households owning equity.

INTRIGUING IDEA. Financial consultant Bert Ely has put forward the most intriguing idea: In a market-dominated world, the Fed should stop pegging short-term rates. Instead, let short-term interest rates fluctuate as freely as the long end of the market does now. Short-term interest rates would then respond even faster to real events of an inflationary or deflationary nature, such as lower unemployment numbers or spikes in crude oil prices. "Inflation is not the threat it once was because market forces have become stronger and much more effective in fighting inflation," says Bert Ely, head of Ely & Co.

Fact is, inflation isn't the danger that it once was, in large part because of technological innovation, international competition, and the rise of market forces around the globe. Market efficiencies tend to minimize inflationary pressures. The upshot: Fed policy may need to shift in coming years from a focus on price stability to staving off recessions and preventing financial panics.

In a global economy, perhaps the Fed should stand back until the economic system requires rescue by a lender of last resort. But until then, the economy could use the stimulus of another half-point cut in interest rates. Alan, do the right thing. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over National Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BW Online

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