Commentary: Why the Fed Should Stick to Rate-Cutting

By Rich Miller

To most people, the Federal Reserve looks to be pulling out all the stops in its drive to repel a recession. In the three weeks following the terrorist strikes, it cut its target for short-term interest rates twice, to 2 1/2%. The latest reduction, on Oct. 2, was the ninth this year and left rates at their lowest level in four decades. And the Fed has promised more to come.

But as far as a small band of supply-siders is concerned, that's not nearly enough. They contend that the Fed is behind the curve in fighting the deflationary forces rippling through the economy. And to make matters worse, they charge that the Fed has actually tightened the monetary screws recently, despite its latest two rate cuts.

How can that be? Well, in the immediate aftermath of the crisis, the Fed pumped tens of billions of dollars into the economy by buying bonds from securities dealers and by lending money to banks. It was an all-out effort to keep the financial system running and make sure that banks and brokers had enough money to keep dealing. As a result, the banks' excess reserves--the money they hold over and above what is required by the regulators--soared. From a daily average of just $1.5 billion before the attack, excess reserves grew 26-fold, to $39 billion, in the two weeks ended Sept. 19. The Fed even let the overnight rate that banks charge each other fall to close to zero at one point, well below its then-stated target of 3%.

MOPPING UP. But as the financial markets returned to some semblance of normality, the Fed gradually began mopping up much of that excess money. Bank reserves have now fallen back significantly, and in the process, short-term interest rates have moved back up to their intended target level. That has the supply-siders, led by economist Lawrence A. Kudlow and former GOP Vice-Presidential hopeful Jack Kemp, howling in disbelief. They charge that the Fed is robbing the economy of the very liquidity it desperately needs right now. "The Federal Reserve has still failed to come to grips with the fundamental cause of the economic slump: namely, a lack of liquidity," says former Reagan Administration official Kudlow. He was one of five economists who recently met Vice-President Dick Cheney to discuss how to rescue the economy.

As far as this cohort of supply-siders is concerned, the Fed is making a mistake by targeting interest rates. Instead, it should continue to pump billions of dollars in excess reserves into the system and let the market determine where rates end up. By targeting bank reserves rather than interest rates, the argument goes, the Fed would provide the markets and the economy with the liquidity they need.

The supply-siders' criticism of Fed interest-rate targeting harks back to that made by monetarists in the 1970s. But rather than targeting money-supply growth, today's Fed critics prefer to judge monetary policy by looking at financial and commodity market indicators. And they don't like what they see. Commodity prices are continuing to fall, despite the Fed's repeated rate cuts. And the government debt market, too, is signaling that the Fed has more cutting to do; the yield on the 91-day Treasury bill now trades a quarter-point below the central bank's 2 1/2% target.

BIG ADJUSTMENT. There's no doubt that a case can be made that the Fed needs to ease credit further. But the risk is that the radical measures advocated by the supply-siders could end up doing more harm than good. By shifting the Fed's focus, they would introduce a lot more uncertainty into the economy at a time when consumers, companies, and investors are already pulling back in the face of an unclear outlook. "It would take months for the markets to adjust," says consultant Louis Crandall of R.H. Wrightson & Associates.

What's more, there's a real danger that such a sweeping shift could eventually reignite inflation, which would spook the bond market. If investors thought that the Fed was shifting to a policy of pumping money willy-nilly into the system, they'd dump bonds, sending long-term interest rates on everything from home mortgages to corporate debt soaring. That very real risk hardly seems worth taking to gain the questionable benefits of dulling the Fed's razor-like focus on rates.

Miller covers the Fed from Washington.

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