The Picture-Perfect Fed
So now the Fed has taken all the rate cuts back. Last summer and fall, when
it sometimes felt as if the global economy were on the verge of a massive
nervous breakdown, the Federal Reserve cut interest rates three consecutive
times--including one between-meetings rate cut--to ensure that suddenly panicky
lenders didn't strangle access to credit. The U.S. economy, perhaps as a
result, didn't even hiccup, while the stock market, which had plummeted in the
wake of Asian turmoil, Russian devaluation, and the collapse of Long-Term
Capital Management, came roaring back. But after today's 25-basis-point rate
hike, the federal funds rate now stands at 5.50 percent, exactly where it was
before the chaos of last summer.
To me, this looks like nearly picture-perfect central banking, especially
since the U.S. economy continues to grow at a fast pace, unemployment continues
to shrink, and inflation at the consumer level remains in check. There are
voices of dissent who think that Alan Greenspan is paying too much attention to
Wall Street and that the continued rise in stock prices is entirely the product
of the Fed's distribution of easy money. But that case has been weakened not
only by the Fed's own rate hikes but also by the powerful rally in the bond
market in recent weeks. Thirty-year interest rates are back down near 6
percent, after trading close to 6.5 percent, and they would not be there if
bond traders--for whom vigilance about inflation is a cardinal law--thought the
Fed was letting us all live high on the hog by printing lots of greenbacks.
In any case, Fed-watching has become so ubiquitous that it's harder to say
something new about Alan Greenspan than about Martha Stewart. But there are two
important things to keep in mind about this most recent hike. The first is that
even if the Fed's performance over the past year and a half looks perfect, we
don't actually know if it was. By this I mean something more than just the
obvious point, which is that history has no control group. I also mean that the
most important driver of non-inflationary growth--business
productivity--remains something of a mystery to economists.
Productivity growth remains very strong, at 4.1 percent in the most recent
quarter, though the rate of that growth has slowed slightly (very slightly).
And it seems increasingly clear that the effects on productivity of
computerization and the Internet are real and not temporary blips. But why
those effects are being felt now, how long they will last, how much of
productivity growth is being driven by businesses running leaner than they once
did: These questions don't have firm answers. Nor, for that matter, do we
really understand why productivity growth slowed so rapidly in the 1970s. So
while the Fed deserves credit for its performance, most of what's going on in
this Goldilocks economy is out of its control.
The second thing worth noticing is that the popular understanding of the
role of the Fed seems to have shifted in the past year and a half, arguably as
a result of its quick action last year. The conventional wisdom was that it
took six months to a year for a Fed rate hike to work its way into the economy,
which makes sense since raising or lowering interest rates generally isn't like
slamming a door open or shut. It's more like easing it open or closed. But what
we've seen more recently is the idea that one of the Fed's key roles is
psychological. It wasn't the literal opening of the taps last fall that
mattered but rather the symbolic message the Fed sent lenders, which was that
it was OK to take on a little risk at a time when the only thing anyone wanted
to do was buy 30-year U.S. bonds. Similarly, no one really believes that
raising the Fed funds rate from 5.25 percent to 5.50 percent is going to put
the brakes on economic growth (although the gradual rise from 4.75 percent to
5.50 percent has to have had some effect). But people do believe that it will
send the right message to lenders and borrowers. To be sure, ultimately the
message carries weight because it's backed by the Fed's actions. But in
concrete terms, the Fed's actions probably won't have an effect for six
months to a year. The Fed's message, though, is already at work right now.
