The Federal Open-Market Committee’s decision Tuesday to leave its target interest rate unchanged surprised no one. Under Alan Greenspan, it adopted a practice of changing course only after prior warning. It had not given such hints after its November meeting. Any move now would have been highly unusual.
What is uncertain is when the Fed will make any change at all. Some pundits, particularly on Wall Street, hype a rate cut in early 2007. They should not hold their breath. A prudent FOMC will not rush.
Moreover, current uncertainty illustrates the folly of trying to fine-tune an economy with monetary policy. Unfortunately, most journalists and members of the general public assume that fine-tuning is the Fed’s job. For three decades, all popular economics textbooks propagated the Keynesian idea that central banks should curtail the money supply when inflation threatened and increase it when unemployment occurred.
That works neatly on a blackboard but is hard in practice. Success depends on three key assumptions. First, that inflation and unemployment are neatly alternating phases of an economic cycle and never occur at the same time. Second, that Fed officials can recognize exactly where we are in the business cycle. Third, that changes in the money supply affect the economy consistently after highly predictable intervals.
None of these is true in real life. The 1970s taught us how easily we can have unemployment and inflation simultaneously. Decades of experience demonstrated that business cycles may be clear in retrospect but extremely hard to identify in real time. The same experience shows that monetary changes take effect unevenly and only after long and variable lags of six to 18 months.
All these factors combine to make micromanagement impossible. Yes, many economists still believe the Fed should increase the money supply in the face of a clear recession and crimp money growth before inflation breaks out.
Such cautious responses, however, are far from the sort of detailed “pull out this stop, step on that pedal” economic organ playing that some Wall Street types still fantasize about.
Ben Bernanke and other FOMC members clearly understand the lessons of the past 40 years. A central bank can maintain a stable price level, warding off both inflation and deflation. That is nearly all it can do. In the long run the Fed cannot increase employment or make an economy grow faster. Even in the short run, what it can do to counter rising unemployment is limited.
The Fed, like everyone else, sees the economy “through a glass, darkly” to use a biblical phrase. It is not clear what is going on right now. In the face of such uncertainty a central bank needs to focus on what it clearly can do (ensure stable prices) and avoid any wild goose chases after things that it cannot catch — like perpetually low unemployment and rising stock market indexes. The Fed should not think about cutting rates for a long time.
© 2006 Edward Lotterman
Chanarambie Consulting, Inc.