The Fed Should Sharpen Its Ax

The Federal Reserve Board has been nibbling around the edges of the economy's problems long enough. The country's economic troubles run much deeper than the gulf war's downbeat impact on consumer psychology. Peace will do little to relieve the financial strains on consumers and businesses. If the central bank is serious about economic recovery, it must cut interest rates much further or take more direct actions to stimulate the growth of bank reserves, the raw material of money and credit.

The evidence doesn't support the popular view that the Fed has eased policy aggressively. During the past four months, the Fed has cut the federal funds rate--the cost of interbank funds--by two percentage points, a drop of about 25%. In the previous four recessions, the rate has fallen an average of 55%. Moreover, the recent cuts have been largely in tandem with market forces, not an overt effort to get interest rates lower. The Fed's two cuts in the discount rate, totaling one percentage point, have been meaningless except to keep the rate in line with that for federal funds.

These moves, including the Fed's December cut in the reserve requirement, have not boosted overall reserves. Reserves haven't grown since 1987, which explains the ongoing slowdown in the money supply. Recent weekly gains in broad money measures have been in currency and money-market funds. These components have little to do with customers' desire to borrow or banks' willingness to lend. Simply put, neither the economy nor the banks can recover until the consumer-related components of money growth pick up.

Targeting reserve growth directly would assure a pickup in money and credit. But if the Fed has chosen to work its policy magic through the federal funds rate, then further cuts are needed to spur bank lending and consumer borrowing. Moreover, lower oil prices, which brighten the inflation outlook, create the right climate for the Fed to cut further.