Fed May Have Moved Too Slowly

Summer 1989 finds the U.S. economy reaching a series of milestones. First of all, July may have marked the 80th month of economic expansion--tying the record for the second-longest upswing in history set during World War II. Second, after a year and a half of progressive tightening, the Federal Reserve eased monetary policy in June. The stock market indexes reached post-crash--and in several cases, all-time--highs. Meanwhile, inflation, as measured by the 12-month percentage change in producer and consumer prices, hit one of the highest rates in seven years.

The combination of events makes the outlook for business extremely murky. The age of the expansion alone (more than twice as long as the average postwar peacetime upswing) would seem to warrant a cautious approach. What is more, signs of softness have undeniably appeared, proliferating to the extent that a number of observers have begun to question whether the economy is still, in fact, growing.

Growth slowed progressively throughout 1988 and the first half of this year. The gross national product expanded at an annual rate of only 1.7% in the second quarter of 1989, down from 3.7% in the first quarter and the slowest quarterly rise in three years. In addition:

- Industrial production has declined in three of the past five months.

- Capacity utilization has fallen in four of the past five months.

- Factory employment dropped for three straight months, sending the jobless rate back up to 5.3% by midyear, although there was some modest improvement in both statistics in July.

- The actual movement of goods off retailers’ shelves has been declining almost nonstop since the beginning of this year and is well below levels first reached back in September, 1986.

Inventories are starting to pile up and at retail are at one of their highest levels relative to sales in at least two decades.

- New orders have softened, while backlogs, excluding aircraft, are down for four straight months.

- Both residential and nonresidential construction have weakened dramatically this year.

- Export growth has slowed because of the rise in the value of the dollar, coupled with higher interest rates abroad.

- The government’s index of leading economic indicators has fallen at an annual rate of 2% from its highs of earlier this year.

Given this overwhelming evidence of a weakening economy, it is not surprising that the Federal Reserve eased policy. The issues now are: Why did the central bank wait so long? Just how much has the Fed actually eased? And is this enough to avert a recession?

It is no secret that managing the economy is extremely difficult for the Federal Reserve--even under the best of circumstances. This is because economic data is always incomplete and because monetary policy affects the economy with a lag.

It has become even tougher of late because the central bank has had no help from fiscal policy. While monetary policy was trying to restrain activity, fiscal policy, in the form of the widening budget deficit, was pushing it ahead.

These factors alone forced the Fed to tighten more than it might have in the past. But the Fed may also have been misled by the failure of one of its intermediate targets for monetary policy to signal just how tight money really was.

Before 1983, the Fed focused on non-borrowed reserves (money banks have in their coffers) in the banking system as its main control instrument. Its aim was to achieve a rate of money supply growth consistent with sustainable economic growth in an environment of price stability.

But financial innovation and deregulation weakened the link between money and the economy, causing the Fed to shift to a borrowed reserves-based operating procedure. The Fed reasoned that, rather than go back to pure interest rate targeting, it would attempt to gauge market pressures by the degree to which member banks would borrow from its discount window in response to a widening or a narrowing of the gap between the discount rate and the federal funds rate.

Bank borrowings used to correlate with the change in the gap between the federal funds rate and the discount rate. However, since early last year they have failed to do so. This was not a sign of less market pressure. Rather, it reflected several developments:

- The switch in 1984 to biweekly from weekly reserve maintenance periods meant that those banks that did avail themselves of the Fed’s discount window had to do so only half as often.

- The need to improve capital ratios has caused many banks to shrink their balance sheets by cutting their loan levels, thus reducing their need for funding.

- Fears of recession, prevalent for the past two years, may also have been a factor causing banks to curtail their lending.

- The banks have become more sensitive to the Fed’s policy intent, thus curbing their borrowing when they perceived reduced accommodation.

- Some banks preferred not to borrow from the Fed, for fear of damaging their image.

More Softening

Whatever the reason, the bottom line is that, even though the spread between the discount rate and the federal funds rate widened to its highest level since the last recession, bank borrowings actually declined. Yet, the surge in the funds rate meant that the Fed was draining reserves from the banking system at the fastest rate in three decades.

Not surprisingly, the money supply tumbled as liquidity increasingly dried up, while rapidly rising interest rates progressively took their toll on the economy.

As these signs of softening became more widespread, the markets themselves pushed interest rates down even as the Fed’s monetary policy remained tight. Such market-driven rates as those on certificates of deposit and commercial paper peaked in March--about a month before the federal funds rate started down.

Even the decline in the funds rate did not represent an easing by the Fed as much as an acquiescence to market forces. The Fed first began to actually push interest rates lower by easing reserve conditions in early June, suggesting that the Fed’s easing of its supertight monetary policy has been only modest, at best.

Thus we are left with the key question: Did the Fed switch in time to avert a recession? The jury is still out, but in view of the evidence presented above, the answer might well be no.