Why the Federal Reserve’s Discount Rate Cut Will Bring On Inflation

On Dec. 20, the Federal Reserve Board shocked the stock, bond and currency markets by announcing a 1% reduction in the discount rate, the rate paid by banks when they borrow from the Fed. A day earlier, the Bundesbank announced a 0.5% increase in Germany’s discount rate.

In my view, the Fed’s move was unanticipated and unwise. The mistake is correctable, but it is unlikely to be corrected promptly enough to avoid a rise in inflation. In contrast, Germany’s recent action will lower inflation.

These opposite actions tell a great deal about the aims and policies of the two central banks. Both Alan Greenspan, chairman of the Fed, and Helmut Schlesinger, president of the Bundesbank, have emphasized their commitment to sustainable, low inflation. Both have acted deliberately and responsibly in the past to lower inflation, and both have succeeded to a degree. But inflation continues in both countries at rates of 3% to 4%.

Inflation is not the only similarity in the positions of the two countries. Both economies are sluggish. At the time of the December announcements, the unemployment rate was 6.8% in the United States and 6.3% in Germany. (The rate subsequently was adjusted to 7% in the United States.) For third-quarter 1991, the United States reported growth of real output of 1.7%; Germany (West only) reported a decline of 1.9%. In the most recent three months reported, industrial production fell 3.4% in western Germany but rose 1% in the United States.

Standard forecasts for 1992 suggest that output in both countries will grow about 2% after adjusting for inflation. Forecasts are often wide of the mark, but they provide the best information available and, in this case, show that the two economies face similar prospects next year.

Why is there such a marked difference in policy action in the two countries despite the similarities of their positions?

I regret to say I believe that the most obvious reason is also the most likely reason. After months of resistance, and a four-year effort to restore price stability, the Federal Reserve caved in to pressures to reinflate in advance of the election. By acting as it did, the allegedly independent Fed gave as clear a signal as can be expected that it will do all it can to assure that it will not be blamed for the defeat of President Bush or any congressional incumbents who seek reelection.

Despite intense pressure from some of its partners in the European Monetary System, the Bundesbank persisted in its policy to reduce inflation. One of the partners, France, has been forced to raise interest rates to avoid currency devaluation despite a 9.5% unemployment rate. Britain and Italy, with unemployment rates of 8.5% and 10%, are likely to follow France and Germany.

The Fed’s capitulation is not a first. In 1972 and 1980, also presidential election years, it shifted to highly expansive policies. Growth of the money supply (currency and checkbook deposits) rose from 6.2% in 1971 to 8.9% in 1972. Money growth surged in first-quarter 1972 and remained high until after the election. Inflation increased subsequently and, with the election over, the Fed moved to restrict money growth and slow inflation.

In 1980, the Fed did not begin its expansive policy until late in the year. A main reason was that inflation was in double digits. To combat inflation, the Carter Administration imposed credit controls early in the year. Once these controls were removed, the Fed raised money growth from an average annual rate of less than 1% in the first half of the year to 17% in the five months ending in November.

This time, money growth rose from 4% in 1990 to 8% in 1991 and will now go higher. Sustained monetary growth at this rate will undo the progress against inflation achieved by the restricted money growth of the previous three or four years. Unless money growth slows soon, inflation will rise.

I recognize that there is widespread support for “doing something” to get the economy growing faster. There is a strong case for policies that would raise long-term growth by reducing government regulation, increasing productivity and improving the educational system. Faster monetary expansion cannot raise long-term growth; at most, it can give a temporary lift to spending.

If we are unwilling to live with higher inflation, we will have to reverse direction by slowing money growth, presumably when the election is over, as in 1972 and 1980. Slower money growth will be followed by slower growth of output or another recession.

Some defend the current policy by pointing to the slow growth of broader measures of money that include time and saving deposits. There is only false comfort in these numbers. The slow growth of these monetary aggregates reflects the very low interest rates that banks and other financial institutions pay to those who lock up their deposits for two, three or five years in certificates of deposit. With long-term rates far above short-term rates, most of the public do not want to roll over their expiring certificates at current low interest rates, so they park their deposits elsewhere waiting for interest rates to rise. Most of this money ends up in checkbook deposits.

The principal cause of current high money growth is Fed actions supplying bank reserves. Bank reserves are the raw material from which new deposits and money are created. For the four years prior to 1991, bank reserve growth was about zero. In 1991, bank reserves rose at an 8% annual rate.

Watch your wallets. We are off on another round of stop and go. And we won’t be free of this problem until we legislate a rule that removes the Fed’s power to inflate when it suits its purpose.

University and a visiting scholar at the American Enterprise Institute.