The Fed did not surprise anyone Wednesday when it finally acted to slow the growth of the money supply. While the one-quarter percentage point change in the Fed funds target rate, to 1.25 percent, was modest and entirely expected, it is the first time the Fed changed in any direction in the 13 meetings since November 2002.
And, it is the first move to tighten since May 2000, when the target was raised from 6 percent to 6.5 percent.
What remains to be seen is how quickly additional tightening will occur and how the economy will respond. That depends on how other factors outside the Fed’s direct control play themselves out and on the Federal Open Market Committee’s willingness to move with alacrity if needed.
The fact that the last move to raise rates was from a starting level six times as great as Wednesday’s gives a perspective on how “accommodative” the Fed has been since spring 2001. (Accommodative is a euphemism describing a situation where the money supply grows faster than output.) The move also indicates how much the Fed has yet to tighten before short-term rates return to levels that prevailed for most of the past 20 years. During that period, short-term rates below 5.5 percent or so generally have been considered “accommodative.”
It has been commonplace in recent weeks to encounter commentaries suggesting that the Fed is likely to raise its target to 2.5 percent by the end of 2005. If the FOMC sticks to its recent pattern of taking baby steps, that would imply five quarter-point increases in the next 12 FOMC meetings. Few observers are willing to predict when rates will climb back above 5 percent.
There simply are too many jokers in the monetary policy deck at the moment. The rate of growth of the U.S. economy and employment is one. The effect of large ongoing U.S. budget deficits relative to national savings is another. The price of the dollar in terms of other nations’ currencies is a third. Growth or lack of it in China, Japan and the European Union also is important and unknown.
Fed action is particularly hard to anticipate because, under the leadership of chairman Alan Greenspan, it has clung to subjective, seat-of-the-pants decision making. Conservative economists, led by Milton Friedman as many as 50 years ago, long have wanted less discretion and more rules in managing money growth. Discretionary policy-making, they argued, has a bias toward inflation in the long run.
The original Friedman prescription of a pre-set and largely unvarying rate of growth of the money supply has fallen out of favor among economists, largely because it depended on the assumption that the velocity of money is not constant and therefore steady money growth need not necessarily foster a stable price level.
The search for some objective reference for monetary policy continues. One such reference is the Taylor Rule, developed by Stanford economist John Taylor, now undersecretary of the Treasury for international affairs. Taylor proposed managing money growth so that the target for short-term interest rates would be determined by: 1) actual inflation relative to some inflation “target” set by the Fed; 2) where economic output is relative to a “full employment” level; and 3) what level of interest rates would be consistent with “full employment.”
Studies show that if the Fed had followed the Taylor rule in the 1990s, its actions would not have been all that different from those actually taken without an objective guidepost.
Other economists call for the Fed to set an explicit target for inflation, probably in the zero to 2 percent range and then manage the money supply to achieve that level of inflation, disregarding other factors such as unemployment or actual interest rates. Several smaller countries have adopted such a target, but the Fed remains unconvinced.
In the absence of rules, capital markets will continue to be swayed by hints contained in the FOMC’s explanatory statements. Analysts particularly seized on two such statements Wednesday: “Rate increases can be at a pace that is likely to be measured,” and “The committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.”
In plain English, the FOMC members mean that they do not intend to raise rates hurriedly, but that they are willing to act decisively if they think it necessary.
All we really know is that policymakers are likely to manage the money so that interest rates will climb over the next two years. But how fast and far they climb is anyone’s guess.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.