Fed Risks Creating a Recession

REPORTS of rising inflation have dominated financial news so far this year. Market analysts quoted in the press talk of the need for the Federal Reserve to ``tighten'' policy to combat this rising trend of inflation.

Unfortunately, current policy has no effect on current price increases. If the policymakers persist in raising interest rates and contracting money and credit until they ``see the whites of the eyes'' of falling output and employment and lower inflation, it will be too late to avoid at least a mild national recession.

Economists disagree on many things, but they do agree that monetary policy affects inflation with a fairly long lag - usually about two to three years.

Back in 1985 and 1986, for example, Treasury Secretary James Baker and Federal Reserve Board chairman Paul Volcker decided it would be a good idea to drive down the value of the dollar on foreign-exchange markets.

The objective was to help exporting companies and make imports more expensive in order to reduce the United States trade deficit. Monetary growth for those two years was very rapid, the dollar fell dramatically as intended, and the trade deficit finally started to fall in 1988.

Now, however, the unavoidable result of that policy - higher inflation - is starting to show up. Starting last spring, the Fed began tightening up to restrain the buildup of inflationary pressures. But, current anti-inflation policies mainly reduce output and employment in the short run, and won't affect price increases until much later.

Meanwhile, the Fed has become a victim of its own rhetoric.

Statements by Fed officials have led market participants to expect that rising inflation, or above-average economic growth, will be met by policy actions to raise interest rates. Market interest rates start to rise in anticipation of Fed tightening actions, and the policymakers feel forced to follow through, even if they believe the economy will soon start to cool off.

If the Fed failed to ratify market expectations of tightening actions in response to higher inflation, portfolio managers might get the idea the Fed was ``caving in'' to political pressures from ``easy-money populists'' in the White House and Congress. That idea would cause the inflation premium in long-term interest rates to increase, and bond yields and mortgage rates would rise.

A way out of this policy dilemma would be for the Fed to announce that it is simply going to let supply and demand in the credit markets determine interest rates, as Paul Volcker announced in the credit crunch of 1979. Instead of trying to control interest rates, the Fed would set targets for slow, steady growth of bank reserves and the money supply.

Total bank reserves already have been falling for about nine months, and the growth of all measures of money have slowed sharply.

If reserve growth is not resumed soon, a recession will become a certainty. The ``soft landing'' the Fed has been hoping to engineer is desirable, but they are now risking the historic mistake of staying too tight for too long.

Policy actions since last summer have been restrictive enough to insure a significant slowing of economic activity and to prevent a rising trend of inflation. It is now time to return the focus of policy actions to the longer run by returning to the midpoints of the announced target ranges for money growth.

You've read  of  free articles. Subscribe to continue.
QR Code to Fed Risks Creating a Recession
Read this article in
QR Code to Subscription page
Start your subscription today