The Fire Needs More Wood, Mr. Greenspan
The Federal Reserve's efforts to put the recovery on solid ground are feeble. We applaud its Sept. 13 cuts in the federal-funds rate and the discount rate, but those actions were justified weeks ago by the increasingly shaky recovery, by the worrisome slowdown in the broader measures of the money supply, by the tightness in bank lending, and by the bright prospects for lower inflation. The economy's financial wounds need the binding only a healthy economy can provide. The failure of the central bank to move boldly has led to continued bleeding.
One problem is the Fed's insistence on targeting interest rates. The Fed arbitrarily sets the federal-funds rate and then supplies to the banking system whatever reserves are necessary to achieve that rate. Reserves are the raw materials that the banks use to create money. If loan demand is weak, the target fed-funds rate is too high to stimulate the economy. In the past, interest-rate targeting often has led monetary policy to respond too slowly to shifts in economic conditions. That is an acute concern right now, when the economy is already less responsive to lower rates because of its financial problems. The result could be a recovery that falls short of even the Fed's modest expectations, or even worse, an upturn that fizzles out.
If the banks are reluctant to lend, and business is reluctant to borrow, interest-rate targeting allows the money supply to go haywire. M2, the Fed's favorite money measure, has now plunged through the floor of the central bank's target range. M2 fell in both July and August, the first two-month decline since the central bank began keeping monthly records in 1959.
Fed Chairman Alan Greenspan has rightly termed the relationship between M2 and gross national product "one of the most enduring in our financial history." And that means that there is a glaring inconsistency in the chairman's policy. The Fed's own forecasts for real gross national product and inflation imply growth of nominal gnp between 5% and 7%. But there is no way that is going to happen as long as M2 is growing at a meager 2.5%-unless money turns over far faster than its long-term trend. That isn't likely when interest rates are falling.
Breathing life into borrowing and lending will not be easy. Many consumers and businesses are too busy paying down old debt to take on new loans. And banks are less willing to lend because they must devote more funds to shore up weak balance sheets, meet higher capital requirements, and satisfy the regulators. Many big banks still have not cut their prime rate, despite the widest spread on record between the prime and banks' cost of funds.
We aren't calling for a return to money-supply targeting and the strict monetarist principles of the Fed under Paul A. Volcker. But more cuts in the fed-funds rate are warranted until interest rates hit a flash point that sparks lending and faster growth of the money supply. The worrisome economic data tell us we are not there yet. Next time, a half-point reduction may even be justified instead of the overly cautious quarter-point cuts the Fed has employed.
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