Beyond Fed Easing

April 29, 2008

It is extremely likely that the Federal Reserve will cut its key interest rates tomorrow by 25 basis points. Articles in the business press have said that is the most likely outcome, and monetary officials have said nothing to suggest that a different outcome is possible or probable. The speculative component of Fed watching surrounds what the Fed does afterward, and the signs there point to a pause. Depending on how the U.S. economy reacts to the substantial monetary stimulus that is in the pipeline and to tax rebates this quarter, the pause may segue into eventual rate increases or into a resumption of rate reductions.

Regardless of what follows after mid-2008, a point will come when it will be safe and appropriate to return interest rates to a neutral setting that neither promotes nor retards economic growth. Fed officials have agreed to undertake that task as aggressively as they have loosened policy, lest this whole business cycle leave the economy laden with more inflation than when it began. Unfortunately, it is much easier to cut rates rapidly than to raise them, and the proof of that lies in Fed behavior since 1999. A decline in the Federal funds target of 325 basis points between September 18, 2007 and April 30, 2008 represents an annualized reduction of 508 basis points. Such is virtually identical to the 507 basis-point per year drop between January 3, 2001 and December 11, 2001 that took the rate from 6.0% down to 1.75%. The last two major cycles of rate increases were also very similar but far more gradual than the pace of change when rates had fallen. In the two years to mid-2006, the rate climbed 213 basis points per year, and between mid-1999 and mid-May 2000, it advanced by an annualized pace of 199 basis points.

A speedier increase in rates was tried in the 362 days to February 1, 1995, when the Federal funds target increased by 302 basis points annualized. That’s still much less than the slope of the last two rate cut cycles, yet it was rapid enough to curb economic growth from 4.7% at a seasonally adjusted annual rate in the first half of 1994 to 0.9% in such terms by the first half of 1995. Monetary policymakers will guard against the danger of oversteering the economy into a recession and invariably increase rates much more gradually than they have cut them. But here’s a problem with such a plan. The fallout from short-term interest rates to economic growth and inflation is affected by both the speed of change in rates and by their level. The Fed funds rate bottomed in the last cycle at 1.0% and will bottom in this one at no higher than 2.0% and most likely lower than that. These troughs represent abnormally low inflation-adjusted levels, a very accommodative stance indeed. It will take considerable elapsed time to restore a neutral monetary policy if the Fed does not tighten at least as quickly as it did in 1994-5. Reversing the present stance without incurring the next major U.S. economic imbalance is going to be easier said than done.

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