Fed Issues That Need to Be
Jude Wanniski
June 30, 2004


We can assume with the rest of the universe that Federal Reserve Chairman Alan Greenspan will preside over a decision to raise the fed funds rate by a quarter point to 1 1/4% later this afternoon. The last time funds went to 1.25% from 1% was between 1958 and 1960, when the Federal Reserve was tied to the Bretton Woods gold standard in its management of the dollar and the funds rate floated. Today, we fix the funds rate and the dollar floats independently of gold. My concern is that at no other time in our history has the monetary authority faced this set of circumstances and in a sense is flying blind.

Prior to the creation of the Fed in 1913, there was no federal funds rate to be managed, and no overnight lending rate targeted by the private banks in order to meet government reserve requirements. When Congress created the Fed in 1913 to manage the gold standard with authority to provide a flexible currency, the Fed was bound by the daily need to maintain the fixed dollar/gold exchange rate. It set reserve requirements, member banks borrowed from each other to meet those requirements before they closed their books each business day. However, this rate floated depending upon the need for funds. Except during periods of crisis in the financial markets (such as the Wall Street Crash of 1929), the interest-rate yield curve generally ranged from about 1% for short money and 4% for 20-year money. There were no Fed governors, Fed watchers or academic economists writing papers on the natural funds rate being 3.5% or even 4.5%, which is what we find all about us these days.

This flimsiest of theories rests on the ideas of Knut Wicksell, a Swedish economist who wrote about a “natural rate” of interest at the turn of the 20th century. I can appreciate Wicksell in the context of his times, but the entire civilized world was on a gold standard back then, and his thoughts have almost no relevance in a world of floating currencies. It is comforting to know that Fed Chairman Alan Greenspan wants to proceed at a measured pace if the rate is to go that high, but we have resisted the idea that it needs to be raised at all. If we were on a gold standard, the Fed would be required to target the gold price instead of the funds rate, and at the FOMC meeting today it would have no choice but to discuss only monetary options outside of the fixed gold price (i.e., reserve requirements and the fixing of the discount rate). The markets would pay little attention to the meeting because there is almost no damage the Fed can do to the financial system if it keeps its commitment to maintain the dollar/gold price.

If you recall our “Best Case Scenario” of April 15, we hoped that the news between then and today’s meeting would cause the Fed to hold off action for another six weeks, to the August 15 meeting. One reason of several we offered was that the dollar/gold price was as high as it was then (around $400) was the geopolitical risks associated with Iraq and the Middle East. If there could be a smooth transfer of power to an interim government on June 30, geopolitical risk would recede, economic actors would feel better about doing business, the demand for liquidity would increase, and the gold price would fall without having to be driven down by the Fed. You surely noticed the $10 gold price decline yesterday when the handover in Baghdad took place two days early. If the Fed were just a bit more patient today, it could hold to 1% and take note of the change of direction of the gold price and the possibility that things may look even better at the August meeting. We are sure that this will not happen, but the debate should begin now within this context on how to approach the next meeting. Certainly, it would be nice to stop hearing about the Wicksell argument, which has mainly been initiated by supply-siders who have been promoting it on CNBC.

If you did not see my public “Memo on the Margin” yesterday, it is an unusual one in that I co-authored an op-ed with Jamie Galbraith, the economist son of John Kenneth Galbraith, on this topic. It appeared in yesterday’s Washington Times and has been getting some attention, perhaps because Jamie and I are an odd-couple, Keynesian and supply-sider. You should note that Galbraith at least expresses “nostalgia” for Bretton Woods, which after all is a gold-based system. Our intent was to open up a debate that should have been taking place outside the Fed on how to deal with the issues of inflation and deflation. It remains my view that if the debate opened up after today’s meeting, Greenspan would find some sympathy for the arguments we make in the op-ed.

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Rate Hike Reservations
by James Galbraith and Jude Wanniski
Published June 29, 2004 Washington Times Commentary

One of us is the First Supply Sider. The other is the Last Keynesian. One is Republican; the other Democrat. One helped invent Reaganomics; the other spent four years trying to stop it.

Yet we agree on one thing. Alan Greenspan should not raise interest rates now or in the near future.

To begin, there is no evidence of a monetary inflation. If that were happening, gold prices would go up. But the price of gold has fallen $35 since it touched $430 earlier this year.

And while growth has returned, the economy remains far from full employment. We have enjoyed just a few decent months of job creation. A million jobs in three months is good news. But we remain about 1.3 million jobs below the actual level of payroll employment four years ago. We`re still about 5 million jobs short of what we should have, given population and labor force growth since then.

Economists once argued inflation would not only rise, but also accelerate in a destructive spiral leading to hyperinflation -- if the unemployment rate fell below a threshold level called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU.

But where was that threshold? Six percent, as many argued 10 years ago? Five and a half? Five? We ran the experiment in the late 1990’s, with unemployment below 4 1/2 percent for 2 1/2 years. Inflation numbers didn`t budge. If the NAIRU exists -- which we doubt -- it isn`t anywhere close to today`s 5.6 percent unemployment rate.

Price pressures exist. Chairman Greenspan was rightly concerned when gold, oil and commodities were all heading higher together. Yet the Fed took the path of patience at that time. Now with real recovery and rapidly rising business profits, liquidity may flow away from commodities toward investment. That would calm rather than roil commodity prices, while financing businesses at low interest rates. With a little more patience from the doctor, in other words, the patient might cure himself.

And oil prices may come down soon, if the Organization of Petroleum Exporting Countries acts as promised. But if they do not come down, that will be due to changing world energy markets and insecurity associated with the Iraq war -- not monetary inflation.

There also are large increases in health-care costs. They have nothing to do with monetary inflation, nor with tight labor markets or rising wages. A better security policy, a better energy policy, and a better health care system would help. High interest rates are not a good substitute for these measures.

What will happen when interest rates rise? We don`t know. But there are several good reasons to worry.

First, in the wake of the refinancing boom, banks and other financial institutions are chock-full of mortgage-backed securities with fixed and low yields. Rising interest rates will hit their value pretty hard. They could precipitate a sharp fall in their price, as well as in bank stocks, the bond market and equities more generally. To what end? No useful purpose would be served.
Second, American households remain heavily indebted. They will not be squeezed immediately by high rates, because many have converted their debts into fixed-rate mortgages (wisely so, despite Chairman Greenspan`s recent advice to convert to ARMs.) But they will be hit by sticker shock on their next house or car, and we can expect a slowdown in those sectors (indeed, in housing it may be under way already). No useful purpose would be served by this either.

Third, higher interest rates probably will appreciate the dollar. This will help Americans who are consumers of foreign goods. But it hurts Americans who produce goods for foreign markets. And if all commodity prices fall (as they will), other asset prices also will tend to fall -- including the stock market.

In the end, where does this deflationary course of action lead? Toward another slowdown, even a recession, with millions of jobs lost and full recovery delayed. That, through history, is the only way high interest rates fight inflation. We don`t doubt the eventual effectiveness of this strategy. We question, rather, whether it is sane.

On monetary policy, one of us favors the Gold Standard. The other is nostalgic for Bretton Woods. We agree, though, there is nothing wrong with a federal funds rate of 1 percent, and a yield curve rising to around 5 percent on long-term bonds, when we are below full employment and with at most a slowly creeping rise in consumer prices. That was the case in the late 1950’s, the last time the yield curve looked like it does now.

Short-term political pressures in the late 1950s pushed the Fed away from an ideal set of interest rates. America`s problems cannot be solved by raising the overnight funds rate. The Fed would surprise the market by leaving rates alone this week, but it would more likely than not be a pleasant surprise.

James Galbraith is professor at the Lyndon Baines Johnson School of Public Affairs, the University of Texas at Austin, and senior scholar at the Levy Economics Institute. Jude Wanniski is President of Polyconomics, Inc., Parsippany, NJ.

Copyright © 2004 News World Communications, Inc. All rights reserved.

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