Ignore Soap Opera at the Fed: Watch Monetary Policy
IN the last few weeks, the papers have been full of lurid tales of political intrigue in the Federal Reserve System. While much of this reportage was muddled and riddled with errors, the thrust seemed to be that a rebellious clique of hard-line inflation fighters had combined to frustrate Alan Greenspan's efforts to lower interest rates. Even assuming that these Washington soap operas were completely true, they told us little or nothing about monetary policy or the process by which it is made. If anything, they obscured the basic issues: What are, or should be, the basic goals of monetary policy? What role should the White House and Congress play in overseeing their implementation?
The late Allan Sproul, president of the New York Federal Reserve Bank in the 1940s and 1950s, once observed that the Federal Reserve System was independent within the United States government but not of the government. This is a profound statement. It says that the Fed does not rank with the White House, Congress and the Supreme Court. Rather, the Fed is a political institution, which cannot operate for long outside the national consensus.
According to Benjamin Friedman, professor of economics at Harvard University, in practice the Fed's independence is always strictly limited. The notion that the central bank can pursue "an autarchic course, out of line with the remainder of the federal government, simply does not connect to the prevailing realities in the United States."
These basic questions are important at present because Mr. Greenspan has been doggedly pursuing the grail of zero inflation - a target neither the White House nor Congress has been willing to support. A resolution is pending in Congress to require the Fed to "adopt and pursue monetary policies leading to, and then maintaining zero inflation."
Even though this resolution has no chance of passage (its sponsor, Stephen Neal (D) of North Carolina) says he has 10 votes), Greenspan's actions have obviously been aimed at stable prices. Most economists would agree with Greenspan that "by ensuring stable prices," monetary policy can indeed create "a prerequisite for maximizing economic growth."
Where economists disagree, and disagree sharply, is over the short- and/or long-run costs of achieving zero inflation. Lee Hoskins, president of the Cleveland Fed, says flatly "there is no trade-off between inflation and recession." While the transition to zero inflation "would entail adjustment costs," he said, if the Federal Reserve adopted an explicit plan for price stability, "Benefits from such a policy change will be large and permanent, and will far outweigh the costs of getting there."
By contrast, Gerald Corrigan, president of the New York Fed, says that there is a no question that "bringing the underlying inflation rate down from its present rate of about 4.5 percent to something like 1 percent or 1.5 percent will involve costs.... History here in the United States [and] all other countries suggests such costs could be large."
While it was disturbing to get confirmation that Greenspan cannot control his own agency, the politics of week-to-week changes in interest rate targets are trivial in relation to fundamental questions of monetary strategy. Fed watchers should have learned by now that interest rates are generally an unreliable guide to central bank policy.
To fix the federal funds rate in a market where demand is highly volatile, the Fed's Open Market Desk must constantly adjust supply. The demand for credit has been falling for several years. Thus, for much of 1990 and early 1991, the Fed was forced to limit the supply of funds in the credit market to keep rates from going down more than it wanted. Including the jump in the first quarter, total bank reserves have changed little in the past two years, even though rates have been going down.
The critical dimension of monetary policy, of course, is not interest rates but money and how fast it is growing. The Fed was indeed painfully slow in reacting to the recession.
The main monetary indicators were unchanged or lower during the first quarter after adjusting for inflation. However, the Fed has finally responded. Money should be up substantially in the current quarter. That is the main reason the economy is likely to recover by Labor Day at the latest.
Greenspan's commitment against inflation is sincere. But if he overplays his hand the gambit is almost sure to backfire. The deeper the hole the Fed digs for the economy, the greater the pressure for it to reflate. It has happened before. It could happen again. Both actual and anticipated rates of inflation could go higher, not lower, than when Greenspan came to town.