Eons ago, when Alan Greenspan was running the Federal Reserve and transparency was something between him and favored journalists, there was a lot more excitement about policy meetings and changes in interest rates.
For example, in the early 1990s, the U.S. economy was slow to respond to the steep decline in the Fed’s benchmark rate from 9.75 percent to 3 percent. As the rate approached what turned out to be a generational low, economists protested that the Fed couldn’t cut again because it had to “keep its powder dry” — presumably to defend against some future attack.
Another market metaphor was the “open window” (not to be confused with Frederic Bastiat’s “broken window”). The Fed was thought to have a small window of opportunity to raise or lower interest rates, after which the economic news would preclude any adjustment because it would be unpalatable to Mr. Market. Which makes you wonder why a change was advocated in the first place.
Then there’s the Fed-in-the-box routine. Sometimes external events would conspire to keep policy makers’ hands tied, according to this line of thinking. The Asian financial crisis in 1997 created an international deterrent to the Fed’s raising rates. Greenspan couldn’t tighten because the rest of the world needed monetary sustenance. By the time Russia defaulted in 1998, Greenspan had to calm financial markets with three rate cuts rather than minister to the booming domestic economy.
Dissecting the Fed’s post-meeting statements in the hope of finding signs of a shift to a more neutral stance has been fruitless. Despite a word change here or there or a shift in emphasis, the Fed remains firmly in the camp that the risks lie with the failure of inflation to moderate.
And maybe that’s how it’s supposed to be. The Fed’s dual mandate — maximum sustainable growth and price stability — is fine for public consumption: It keeps members of Congress off its back. But as far as policy makers are concerned, price stability is both an end in itself and a means to that end and therefore commands the upper hand.
The idea that a central bank can produce faster growth by tolerating a little more inflation has been “entirely discredited,” Bernanke said last week in a speech to the National Bureau of Economic Research’s Summer Institute in Cambridge, Massachusetts. “Policies based on this proposition have led to very bad outcomes whenever they have been applied.”
If the Fed is worried about the housing slump, increasing subprime loan delinquencies and home foreclosures, deteriorating credit conditions and a ticking time bomb in the derivatives market, there is no sign of it just yet. Or, more correctly, there is no indication policy makers are ready to move off the bench and provide some juice to the economy.
To the extent that easy money created the housing bubble, easy money won’t cure the bust. In an ideal world, the Fed would let the air come out of the housing market and some of the sting out of inflation without doing anything.
Should conditions deteriorate enough to put economic growth at risk, all bets are off. The Fed will ride to the rescue with interest-rate relief, unconstrained by any boxes, windows or dry powder.