Fed's money policy may temper boom-bust cycle, economist says
Has the worst of the old-fashioned business cycle, with its booms and busts, been abolished in the United States? Will inflation remain below the double-digit level for years to come? Michael W. Keran says he thinks it is possible. Formerly chief economist of the Federal Reserve Bank of San Francisco, Mr. Keran sat in on the Fed's monetary policymaking meetings for 10 years.
Since joining the Prudential Insurance Company of America, he explained over the phone and in a published economic review, that the Fed has fundamentally changed its monetary procedures sufficiently to prevent the especially deep recessions such as occurred in 1973-75 and 1982-83.
Keran admits that ``Paul Volcker [chairman of the Fed] has not whispered in my ear what I wrote in that paper.''
But having seen the economic devastation of the recent deep recessions, many of the top Fed policymakers, including Mr. Volcker, have decided to alter monetary techniques, Keran says.
``A good case can be made that since about October 1982, the Fed has followed a new monetary strategy designed to prevent a reacceleration of inflation with the business cycle expansion,'' he writes.
Under ``old monetary strategy'' in the 30 years prior to October 1982, the Fed followed a basically easy-money strategy until a rising inflation rate became a major public concern.
``Monetary policy now becomes restrictive whenever the growth of the nominal GNP [gross national product -- the output of goods and services in current dollars] exceeds some target level, which, if continued, would increase the inflation rate,'' Keran says.
If, for example, the nominal GNP starts growing in excess of the present 7 to 9 percent, the Fed tightens up, because it believes a faster rate of GNP growth will at some point prompt inflation faster than the currently acceptable 4 or 5 percent.
This ``new monetary strategy,'' says Keran, has two implications.
First, it means that monetary policy can be reversed more quickly (in less than a year instead of three to five years under the old monetary strategy) when easy money pushes nominal GNP growth above the Fed's target rate. That's because monetary policy has a quicker effect on GNP growth than it has on inflation.
Such a policy switch happened after GNP raced ahead last spring. The Fed tightened up in the summer. Money growth slowed from June to October, and real GNP slumped in the third quarter. The Fed promptly started creating new money more rapidly. This, Keran predicts, will result in rapid growth in nominal GNP during the first half of this year. Then the Fed will brake again and the second half will again see slow growth, he speculates.
Second, the ``quicker feedback assures that errors in policy are corrected rather promptly,'' Keran says. This avoids cumulative overshoots in the growth of money and nominal GNP. The resulting business cycle should be more moderate, with milder slowdowns or recessions. Business contractions could, however, occur more often.
Moreover, Keran figures the new strategy may prevent inflation from rising back to double-digit levels.
During the 1950s and '60s, he says, the trigger point of inflation prompting tight money was between 3 and 4 percent. In the 1970s it took an inflation rate of nearly 10 percent to touch off a stern monetary policy.
Since there is a relatively long lag between easy monetary policy and the resulting inflation -- usually found to be about two years, the old monetary strategy resulted in relatively long periods of easy money and economic expansion. Because there is a relatively short lag between tight money and higher unemployment, periods of tight monetary policy were short. Thus a typical post World War II recovery lasted eight to 18 quarters; the usual recession extended two to five quarters.
Like some other economists of ``monetarist'' sympathy, Keran suspects shifts in monetary policy are having a more rapid impact on the GNP than in the past. These economists used to reckon it took six to nine months for a slowdown in money growth, for example, to slow down GNP. In the last couple of years this has seemed to occur in about three months.
Citibank economists say this may be because of the extremely rapid or extremely slow spurts in money growth imposed by the Fed on the economy, usually for periods of about six months in the last two or three years.
Lawrence Kudlow, top economist at the Office of Management and Budget during the first part of the Reagan administration, also complains of the Fed's ``roller coaster'' policies. Now an economic consultant in Washington, Mr. Kudlow says the Fed has returned to a ``go-go phase'' with extremely fast money growth.
The result of the Fed's ``unpredictable patterns'' has been wide fluctuations in the movement of interest rates, he maintains.
Some economists further argue that the uncertainty of interest rates has prompted lenders to demand a higher interest rate as a form of insurance against possible losses.