Monetary Policy Is Not a Panacea

By now, it should be fairly evident that the new decade has begun on a weak economic note. Growth of the gross national product in last year’s final quarter was almost non-existent, while output in January slid by the steepest monthly rate in seven years and gained only slightly in February, according to the nation’s purchasing managers.

The financial markets aren’t in much better shape. Bond prices have tumbled since the middle of December, sending the yield on the bellwether 30-year Treasury bond soaring by over 0.75 percentage point to nearly 8.67% at one point recently--its highest level since last spring.

This year hasn’t been kind to stocks either. The popular averages experienced one of their worst Januarys in 30 years and have regained only a small part of the drop since.

Ordinarily, the Federal Reserve Board would respond to these ominous signs by loosening up on money, pushing interest rates down. Although the Fed has eased, it hasn’t eased very much.

Fed Chairman Alan Greenspan and his colleagues at the Fed are aware of the softness in business activity. However, they also worry about other things, such as the rate of inflation. This leads me to conclude that the Fed has a great deal of confidence in its ability to manage the economy--more so than may actually be justified.

It may be true that monetary policy can be used effectively to restrain the economy. But it does not necessarily follow that monetary policy alone can stimulate activity when such a move is called for.

This was the situation in the 1930s. At that time, the economy was spiraling downward. Recognizing that it had tightened money when it should have loosened it, the Fed proceeded to flood the banking system with reserves in the hopes of driving interest rates low enough to stimulate borrowing and increase spending.

Rates came down, all right, but the banks refused to lend and people were reluctant to borrow. This gave rise to the expression, “You can’t push on a string.�

It seems to me that the Fed’s freedom to maneuver is being increasingly constrained by a unique set of developments that I call conundrums:

* If the Fed decides to lower interest rates to stimulate the economy, it may find that foreign investors will pull their funds out of U.S. fixed-income instruments because of the relative attractiveness of rates back home. This would cause interest rates in the United States to rise, as has occurred since mid-December.

* Cutting Washington’s budget deficit to reduce our dependence on foreign funds, thus our vulnerability, might constitute enough fiscal restraint to tip the economy over into the very recession that we’re hoping to avoid.

* Fears in some quarters that the Fed will have to ease to keep us out of a recession have contributed to the run-up in bond yields noted above, making it even more necessary for the Fed to ease.

* Even if the Fed were to ease, it might not do much good, since lenders are becoming increasingly reluctant to lend, while many borrowers are so burdened with debt that they may not wish to borrow any more.

* Anyway, monetary policy is mostly in the hands of the regulators and analysts, who are exhorting the banks to curtail lending to shore up their capital ratios. This is producing the kind of credit crunch that we used to see in the 1960s and 1970s, when there were limits on how much banks could pay for deposits and charge for loans.

* Many people would have little reason to borrow, in any event, since the big-ticket items they would likely purchase with these borrowed funds now cost more than they can afford. Prices of new cars and new homes have gone up much faster than have most families’ incomes during the past two decades.

* Discretionary buying power in general is being chewed up by rapidly rising Social Security taxes and the high cost of medical care, food and energy. These items are obviously outside the purview of monetary policy, yet if the Fed accommodates these increases, they’ll become ingrained in our economy.

* We need a lower dollar to revive exports and curtail imports--both essential to keeping us out of recession. Yet pushing the buck down would very likely increase the inflation pressures that the Fed is concerned about.

Recognizing that whatever they do may be wrong, Fed officials lately have begun to talk about how they believe that the threat of recession is receding. In this way, they hope to keep a lid on inflation and interest rates and hold the economy on an even keel.

But if the Fed is no longer worried about recession, maybe the rest of us should be. This is because interest rates are still restraining economic activity.

And if the Fed is waiting for inflation to slow before easing money, it should be aware of one other fact: Most of the reduction in a given rate of inflation tends to occur after the economy has gone through a recession.

In other words: No pain, no gain in the fight against inflation.