Is The Fed Still Too Tight?
Thomas Nugent is chief investment officer forPlanMember Corp. of Carpinteria, Calif.
Background
What is the goal of monetary policy? Should the Federal Reserve Board manipulate the economy by raising or lowering interest rates, or should monetary policy be focused on maintaining the value of the dollar? Over the years it appears as though the Fed has vacillated between these objectives, causing uncertainty in financial markets and swings in levels of economic activity.
During the 1960s and 1970s, Fed policies appeared to favor tinkering with the economy. By increasing the money supply to finance the Vietnam war and the Great Society programs, the Fed took some of the blame for double-digit inflation. By 1979, the Fed became concerned that the loss in the value of the dollar was a major economic problem and that the Fed should shift policy to stabilize prices.
In a Wall Street Journal editorial in 1982, Arthur B. Laffer andCharles W. Kadlec identified the Fed's commitment to a new monetary policy that was designed to eliminate inflation by reacting to changes in the price level. When prices went above or below some arbitrary level, the Fed would tighten or ease by raising or lowering the Fed funds rate until prices returned to a non-inflationary level. The authors chose the Dow Jones Spot Commodity Index as the basic indicator for Fed policy. They also established target bands. The idea was that, if the spot index went above 128, the Fed would tighten and if went below 119, the Fed would ease.
Fed policy has been quite active since the global financial calamity in 1998. As the U.S. economy avoided the Asian contagion, growth spurted in 1999, led by increasing spending on computer hardware and software due to Y2K. In response to inflationary concerns, the Fed began raising the Fed funds rate to preempt an inflationary surge.
The Fed Goes Off The Price Rule
During 1999, there was no indication of inflationary pressures as measured by the Dow Jones Spot Commodity Index. If the Fed were committed to this price rule, then it would have held its ground and not raised interest rates until such a time as the Dow Jones Spot Commodity Index went above the upper band of 128.
The Fed continued to tighten through the end of 2000 even though the Spot Commodity Index remained well below the lower band, indicating that the Fed should have been easing rather than tightening.
The quick reversal in Fed policy in January 2001--almost a panic reaction to a weakening economy--was reflected in six cuts in the Fed funds rate in six months. In reaction to this ease, a growing chorus of economists called for an end to Fed easing. But the question remains: should the Fed stop easing?
If we give credence to the record of the price rule, the Fed must ease. The reason is simple. The Dow Jones Spot Commodity Index has continued to fall, reaching a low of 104 recently, a level that is substantially below the 119 lower target band. Until there is a recovery in prices, at least as measured by this index, falling prices are a sign that money is too tight. Thus, deflation remains the risk.
Conclusion
The Fed's abandonment of the price rule in 2000 has contributed to a slowing economy, falling prices and a global shortage of dollars. If the Fed shifts to a neutral stance now, an economic recovery may be postponed indefinitely. Fortunately, Chairman Greenspan's latest remarks indicate a commitment to further easing if the economy does not show imminent signs of recovery. Let's keep our fingers crossed.
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