The Fed May Need New Tools
The economy is not taking the medicine prescribed by the Federal Reserve Board, and that’s bad for its health. If the central bank is to offer remedies that find acceptance among the American public, it clearly needs new diagnostic tools.
So far the Fed has been jacking up short-term interest rates to cool the economy, but it is as hot as ever and inflationary pressures do not appear to be building. What is Fed Chairman Alan Greenspan to do?
Basic economic theories do not provide all the answers, so economists speculate that Greenspan is trying to invent new ones that would explain the “new” economy. Greenspan himself admits that the Fed and government agencies need to crunch more numbers and take a closer look at the new economy, including what the rising asset prices do to inflation. We agree, but inflation, not the level of stock prices, should be the focus of the inquiry.
The problem the Fed is facing today is the same that confronts macroeconomic analysts in general. They construct their picture of the future by looking at what happened in the past. But in an economy that is undergoing dramatic restructuring, the past is telling them very little about the future.
As Times’ staff writer Thomas Mulligan reported last week, Greenspan believes that the economy is overheating, but he can show little evidence that this is unleashing inflation. Wall Street, once hanging on Greenspan’s every oblique word of caution, last Thursday shrugged off the near-certainty of a preemptive Fed rate hike, expected today, with a record one-day gain. The worry here is not that Greenspan, who has been viewed as having close to divine powers over the economy, is losing his touch, but that raising and lowering interest rates, the Fed’s main tool of fine-tuning the economy, may have been blunted.
Greenspan has come in for a good deal of criticism lately for targeting the stock market as the inflationary boogeyman. He has denied repeatedly that the Fed has a preconceived idea of what a reasonable level of stock prices should be, but he failed to convince skeptics in Congress. He will have to speak on this point much more forcefully.
Clearly, trying to club the stock markets down to some “reasonable” levels would be wrong; the prices are best determined by demand and supply. That does not mean that the Fed should not study the effect that stock prices have on the economy, however. Few would argue with Greenspan that stock prices have an important spillover effect. That rising stock prices lead consumers to greater spending--the so-called wealth effect--appears clear. How that works on the supply side, given the prodigious increase in productivity and the ready inflow of goods from abroad, is less clear.
New economic models may be needed to explain today’s economy, and more data certainly are required. Still, the job lies with the Fed. Its role in guarding against inflation remains unchanged, and interest rate policy is clearly its main weapon.
