The Fed's Pre-Emptive Misfire By James K. Galbraith Special to TheStreet.com 6/29/99 1:51 PM ET
With this column we introduce James K. Galbraith, the noted economist and author of Created Unequal: The Crisis in American Pay. Galbraith is a professor at the University of Texas at Austin and director of the university's Inequality Project <http://utip.gov.utexas.edu/>, a research group concerned with assessing changes in the inequality in wages and earnings and the patterns of industrial changes around the world.
------------------------------------------------------------------------ Something amusing happened last week, on the way to a pre-emptive strike against inflation. Inflation disappeared, like a MiG into a bunker, leaving the Federal Open Market Committee with a meeting scheduled and nothing to bomb.
Not that it will stop them. But what, exactly, do these people who are about to jack up interest rates think they are doing?
Many years ago, there existed economists who believed that the Fed causes inflation directly, by printing money. This school, the monetarists, has now largely disappeared after many years of increasing money and no inflation. But at least one unrepentant monetarist -- Jerry Jordan -- still sits at the table of the FOMC. He will support raising interest rates.
More recently, other economists could be found who argued that if the unemployment rate ever fell below 6%, its "natural rate," inflation would not only increase, but accelerate. Full employment, in other words, meant hyperinflation. Nowadays such people stay out of sight, as they ought to. But there is at least one unreconstructed acolyte of this school -- Laurence Meyer, a Clinton appointee -- still on the FOMC. He will support raising interest rates.
To this pair of obsolete thinkers, one must add a congeries of obscurities, the other presidents of the regional Federal Reserve Banks. The stance of some members of this group is simple: They always favor higher interest rates. Why? The fact that they have a lot of bankers on their boards may, possibly, have something to do with it.
In this company, Alan Greenspan (and his departing vice chair, Alice Rivlin) emerge as heroes: patient, pragmatic, skillful; the architects of a long policy of inaction and of an experiment with full employment that has yielded prosperity and stable prices since 1994. But Rivlin has gone, the ideologues and lobbyists have coalesced, and Greenspan cannot hold to his experiment alone. Nor can a Federal Reserve chairman afford to be outvoted on the FOMC.
Indeed, the best that Greenspan can do is limit the damage. He can work to restrict interest-rate increases to a single, small episode, to reduce the fear that this interest-rate increase will be followed by another, and another. This he is evidently trying to do, as his intricate web of public statements in recent days attests.
And yet, the resulting compromise action, one small increase followed by stability, makes no economic sense. The logic of pre-emptive strikes requires that they be overwhelming. A quarter-point increase in the interest rate would not stop inflation if it were coming. For that, interest rates would have to rise by enough to cause a recession and sharply rising unemployment, a move the Fed made in 1970, 1974, 1981 and 1989. This is the ugly secret behind the strategy of putting the Fed on the front line of the inflation war: Unemployment is the only weapon it has. The small interest increase now in view is therefore useless from the standpoint of its own proponents.
Indeed, it may be worse than useless; it may be counterproductive. Part of the idea of raising rates is to calm the financial markets. But higher interest rates will not dampen speculation. Quite the reverse: They will reduce the flow of credit to lower-income working families -- the mainstays of this expansion -- whose mundane mortgages and installment loans yield low (though secure) profits to lenders.
The mechanism is quite simple: Such borrowers will, at the margin, no longer qualify for loans because at higher rates they cannot meet the payments. The funds will then have to go somewhere else. And where, if not toward higher risks and higher returns? The effect may well be to inflame, rather than calm, the financial markets -- again laying the case for another rate increase, and then another, later on.
A quarter-point, or even a half-point, concession to the rate-raising lobby will not by itself end the economic expansion now. But it could start us down that road. And that is the price we pay for tolerating a coalition of obsolete theorists and special pleaders on the Federal Open Market Committee, the most important economic policymaking body in the U.S. government.