What the Fed Practices Versus What It Professes

ACCORDING to Federal Reserve chairman Alan Greenspan, "since late October, ... the Federal Reserve has moved aggressively ... to ease money market conditions" - presumably to bring the economy out of recession. Unhappily, what the Fed says and what it does are often different. The international value of the dollar has surged more than 10 percent since early February. That's a sure sign that even though short-term interest rates have gone down, money is still tight. If dollars were plentiful, their value would not be rising so rapidly.

The principal result of the Fed's stance is likely to be a more painful recession than either Washington or Wall Street anticipates. Even if the economy shows tentative signs of recovery, this "rebound" could be followed later by a further, deeper decline - a double-dip recession.

Last Friday, the Bureau of Labor Statistics (BLS) published its initial estimate of employment in March. Total employment (the number of people with jobs) dropped by more than 300,000. Nonfarm payroll employment (the number of jobs) went down 200,000. Unemployment jumped by 414,000.

These changes, of course, showed the ongoing pattern of recession in the United States. As a result, the BLS index of aggregate nonfarm hours worked (jobs multiplied by working time) went down at an annual rate of 5.6 percent in the first quarter. Such a drop would be consistent with a slump in real gross national product, the output of goods and services in the nation in deflated dollars, during the winter months at an annual rate of more than 4 percent, double the drop last fall.

While some measures of consumer confidence have rebounded to where they were last summer, both consumer income and spending are still going down after adjustment for inflation. As many bankrupt retailers will testify, the consumer sector (two-thirds of the US economy) has long been in a deep downturn.

At the same time, business investment - which usually falls sharply during recessions - remains vulnerable to a major drop. This is the real significance of the announcement by International Business Machines Corporation that first quarter profits would fall well short of expectations.

IBM is the world's leading capital goods producer. The reason for IBM's woes was not hard to find. The ratio of corporate cash flow to fixed investment has fallen sharply. History shows that changes in that ratio (up and down) are a leading indicator in capital outlays. Companies act just like consumers. In times of trouble, they tighten up. Indeed, contracts and orders for new plant and equipment declined at a rate of 11 percent in the three months ended February.

Meanwhile, Fed data show that all the major measures of the money supply (M-1, M-2, and M-3) posted only modest increases on average during the first quarter of 1991. Adjusted for inflation, these indexes actually declined this winter for the third consecutive quarter.

Granted, currency held by the public has jumped by record amounts in the past year. Even so, this does not change the basic conclusion that Federal Reserve policy has just begun to ease. The surge in currency bloated the monetary base, which can serve as raw material for the money supply. However, almost all the rise in the base can be traced to the surge in currency. When holdings of currency go up, bank reserves go down.

The Fed normally offsets changes in bank reserves that are due to changes in currency by buying or selling Treasury securities. In the past year, that practice has added to the monetary base, but not to bank reserves. Some analysts jumped to the conclusion that rapid rates of increase in monetary base mean that monetary policy is now easy. This was wrong. All of the rise in currency since November 1989 has occurred in only three of the 12 Federal Reserve districts (New York, Chicago, and Atlanta). Banks in these cities are shipping this extra cash to Eastern Europe and Latin America. It is not circulating in the US.

The Federal Reserve's zeal in combatting inflation is commendable. However, a policy that is too tight is no more desirable than a policy that is too easy. The danger is that if Mr. Greenspan ultimately triggers a really deep recession, then he (or his successor) will be forced to reflate. The Fed could end up with more, not less, inflation.