Commentary

The Fed Does Right

The Federal Reserve has cut the fed-funds rate to 3 percent from 5 1/4 percent since last September. Some Fed critics dismiss that as “too little too late.” Others suggest it’s too much or too soon - risking a return of 1970s stagflation. Still others say it won’t matter - that the Fed is just “pushing on a string.”

They’re all wrong.

Jim Cramer, star of CNBC’s “Mad Money,” is still describing Fed policy as tight and Chairman Ben Bernanke as behind the curve. Some who echo that sentiment hold up former Fed chief Alan Greenspan as a better role model. Check the record:

  • The US economy went into recession in the summer of 1990 when Iraq invaded Kuwait and oil prices soared. But Greenspan repeatedly denied the economy was in recession until the recession was almost over in early 1991, and the fed-funds rate was still 6 percent. Long after the recession ended, in October 1992, the Fed cut the fed-funds rate to 3 percent.
  • In 2000, stocks fell sharply after April and industrial production began to fall in July. Yet the Fed kept the fed-funds rate at 6.5 percent until January 2001 and didn’t ease aggressively until after 9/11. In June 2003, long after the recession ended, the fed-funds rate was cut to 1 percent.

Bernanke, by contrast, thinks easing before a recession is wiser than easing two years too late.

Other critics say Fed policy is wildly inflationary. “The Education of Ben Bernanke,” a recent New York Times Magazine cover story, worried that “any rate cut would tend to escalate the stampede out of the dollar” - a stampede that in turn supposedly risks a return to double-digit inflation, “a wage-and-price spiral similar to that in the 1970s.” All such “stagflation” analogies are absurd.

In December 1979, consumer prices were 13.3 percent higher than a year before. Excluding food and energy, core inflation was still 11.3 percent. Compare today’s numbers: Every major measure of core inflation was up 2 to 2.2 percent last year. All such measures have hovered very close to 2 percent since 2001 - much lower than in the 1980s or 1990s, much less the 1970s.

Other critics say Fed policy is wildly inflationary.”

Why focus on core inflation? First, the Fed can’t be expected to do anything about China’s thirst for oil or congressional mandates for moonshine (ethanol). Second, core inflation and overall “headline” inflation become the same once oil and food prices stop rising.

Oil prices fell by 8 percent in January. If that continues, as I expect, headline inflation will be even lower than core inflation. Rents should also fall as “for rent” signs appear on more and more unsold houses and condos - pushing inflation even lower.

Now, economic stagnation - the other half of the “stagflation” story - is another matter. But real GDP in the fourth quarter would have been 1.9 percent if businesses hadn’t been running down inventories - something that rarely lasts long. And, while falling homebuilding has sliced a percentage point off of economic growth since early 2006, no other major economic indicator has yet turned negative, even briefly.

Yes, consumer spending and industrial production in December were flat and employment grew slowly - but “flat” is not “down,” and one month does not prove a trend.

The myth that the Fed is “pushing on a string” means that adding more and cheaper bank reserves won’t help because nobody wants more loans. That’s plainly false: The issue in a “credit crunch” is the exact opposite - people want more loans than the banks are willing or able to make.

Finally, there are those who say the Fed is simply helpless to prevent a recession.

Greenspan, for one, told the German weekly Die Zeit that the Fed could “probably not” prevent recession. (Not that he ever tried.) He argues that short-term interest rates don’t matter - which makes you wonder what he thought he was doing at the Fed.

Economic activity only depends on “real long-term interest rates,” he says, “and central banks have less and less power to influence long-term rates.” In fact, while interest rates on 30-year mortgages and 10-year bonds never rise or fall as much as short-term rates, long-term rates have fallen sharply as the Fed has cut short-term rates.

Besides, short-term rates matter, too: Banks make money by borrowing short and lending long, so pushing short rates down helps banks - the most troubled sector of the economy other than housing. Low short-term rates also make it less tempting for investors to sit on idle cash rather than invest in stocks and bonds.

Lower interest rates have launched a huge mortgage-refinancing boom, and the resulting drop in monthly payments will have the same effect on household finances as a pay increase. Businesses, too, will roll over their debts at lower rates - a more pleasant way to pare costs than layoffs.

In short, the Fed has it about right, so far. Of course, there can be too much of a good thing.

Alan Reynolds is a senior fellow and author of Income and Wealth (Greenwood Press, 2006).