Yes, Virginia, Fed Policy Still Works
By David Wyss
As usual at this time of the business cycle, reporters are writing articles about why Fed policy no longer works. Eighteen months ago, they were writing the same articles explaining why the Fed would not be able to slow the economy. Now, they have recycled the texts, changing the "hikes" to "cuts."
These articles were silly eighteen months ago, and are just as silly today. We are seeing little impact of Fed rate cuts because it is too early. We are already seeing an impact on narrow sectors, particularly housing. Hope for the second half rests clearly on the shoulders of the consumer. A recovery requires us to rush out and spend the tax rebates as soon as they show up in our mailbox.
Fortunately for the economy, consumers seem ready, willing, and able to do so. Despite the weakening labor markets, consumer confidence has begun to recover. We consumers have stopped the investment recession from spreading outside of manufacturing; now, we must lead the economy out of the slowdown.
Monetary policy is slow. It takes about a year for a change in the federal funds rate to affect the economy significantly, although the more sensitive sectors will see more immediate impacts. This lag should have been clear from the 1999-2000 experience. The Fed began to tighten in May 1999, but the economy didn't slow until the third quarter of 2000.
We expect the same this time. The Fed's first easing move was Jan. 3. There is no reason to expect any reacceleration of the economy until yearend. It takes just as long to speed an economy up as it does to slow it down.
Some are arguing that the Fed has abandoned or lost some of the tools that it used to use to control the economy and financial markets. This was articulated recently by Martin Mayer in a Wall Street Journal editorial. He cited the lack of changes in required reserves, nonexistent discount window activity, lack of changes in margin requirements, and the end of limits on deposit rates.
In fact, however, the first two of these policies were always redundant, and the last lost relevance because of deregulation, which was forced by the inflation of the late 1970s and early 1980s. The only one of these policies that might have any practical effect today is margin requirements, and the internationalization and broadening of financial markets, especially futures and options trading, make even that policy of doubtful efficacy.
The Fed's only impact on markets is through its ability to change the cost and availability of capital; if the Fed can control interest rates, it has as much control as it needs. Reserve requirement changes are irrelevant if the Fed can change reserves. The discount rate is irrelevant if it can control the funds rate (with the possible exception of an impact on distressed banks, which thankfully are scarce today). A recent New York Fed conference on monetary transmission mechanisms discussed some of these changes.
The irrelevance of these tools is shown by the Fed's ability to set the funds rate, which has been very tightly under control. If the Fed has lost the tools needed to control interest rates, then why is it so good at setting the funds rate? Either it still has the tools it needs or Alan Greenspan should be captain of the U.S. Quidditch team.
Control over deposit rates (the old Regulation Q) gave the Fed tighter control over the availability of loans than it currently has. The problem with Reg. Q, however, was that it gave the Fed an "on-off" switch rather than real control. When market rates rose above the Fed ceiling, banks could make no loans. The Fed decided that it preferred a more gradual brake rather than a switch. Loans are now always available -- but at a price.
The easing is nearly over. Once consumers start spending their rebate checks, a modest rebound should occur. We expect one more rate cut at the August meeting, since the Fed won't have seen any consumer action yet. But when the economy swings upward in the third quarter, the Fed will stop to see the economy bloom.
Wyss is Chief Economist for Standard & Poor's