Fed Cut in Discount Rate Could Be Risky

When the Federal Reserve Bank recently cut the discount rate by half a point there was little surprise. The action had been widely anticipated, particularly after the German central bank cut its comparable lending rate by a half a percent earlier that same week. Nor was anyone surprised when Japan and other European nations followed suit.

This major step toward a coordinated international monetary policy was accomplished with little fanfare or criticism, despite the fact that both the Federal Reserve and the Reagan Administration only a year ago would have backed away from supporting such coordinated action. Although the Fed’s move in itself was relatively modest, the shift to coordinated monetary expansion is an important change in the Fed’s approach to monetary policy, since the international coordination of interest rates is a major step toward coordinated exchange rates. What has happened in the last few months to explain these actions?

There is no difficulty in justifying the interest rate cuts by the central banks of Germany and Japan. Until recently the Germans were reluctant to relax the tight monetary policy that they adopted several years ago to counter the inflationary pressure of rising import costs as the German mark fell relative to the dollar. But Germany’s unemployment rate is now almost 10%, and its inflation rate is essentially zero. The combination of substantial excess capacity, falling oil prices and a rising mark means that expanding demand in Germany can bring down the unemployment rate but keep inflation low. The Germans realized this, and were prepared to reduce their interest rates.

The Japanese also have been experiencing much slower growth. The 25% rise in the value of the yen relative to the dollar since last fall is cutting into the demand for Japanese products and threatens to slow Japan’s growth even more in the months ahead. The Japanese were therefore eager to reduce their own interest rates in order to stimulate their economy.

So while there was good reason for Japan, Germany and the other European countries to cut their interest rates, the case for the Fed to do the same was far from compelling.

Despite the recent increase in the unemployment figures, there are several reasons to expect that the American economy will expand faster this year than last, leaving the unemployment rate lower at the end of the year:

--The 3 1/2-percentage-point fall in long-term interest rates in the past 12 months is already stimulating a strong demand for housing construction and for other kinds of interest-sensitive consumer spending.

--The sharp increase in the stock market has added about $500 billion to consumer wealth and reduced the cost of funds for corporate investment.

--The 25% decline in the value of the dollar over the last year has made American products more competitive in world markets.

--The sharp fall in oil prices that will halve our nation’s oil-import bill is equivalent to giving consumers a $30-billion tax reduction.

With these factors in mind, it is difficult to justify the Fed’s action by domestic demand considerations.

Why then did the Fed cut the discount rate? One reason was to prevent a temporary rise in the value of the dollar. If the European nations and Japan had lowered their interest rates without a corresponding rate cut by the Fed, our relatively higher interest rates would attract more foreign capital to the United States and might temporarily drive up the relative value of the dollar. But even if the dollar did rise for a few weeks, we believe that the dollar would be pushed to lower levels over the months ahead as investors around the world respond to the sharp decline that has already occurred in U.S. real long-term interest rates, to the reduction in projected budget deficits and to the accumulation of dollar securities in foreign portfolios.

Explicit monetary easing is not needed to keep the dollar on a generally downward path, though an uninterrupted slide in the dollar’s value was desired. The Fed was prepared in the end to accede to this desire despite Chairman Paul A. Volcker’s concern about the inflationary risks of a precipitous drop of the dollar.

The second reason for the Fed’s action was to induce the European and Japanese central banks to cut their interest rates, in the expectation that stronger growth in those countries would mean more demand for U.S. exports. The European central banks, however, feared that an interest-rate cut would depress their currencies and contribute to domestic inflation. The Japanese feared that a weaker yen would exacerbate U.S. protectionist policies against Japan.

The Fed’s discount-rate cut may be justified for these reasons, but monetary coordination is harmful if it artificially sets the exchange rate at a level that cannot be sustained without such manipulations. And it becomes dangerous if it is used as an excuse for monetary expansion when demand stimulation is not justified.