The Fed Should Stay Out of Politics
POLITICIANS and bond traders make strange bedfellows. Yet for the moment they are united. They want the Federal Reserve to keep pushing short-term interest rates down. Simply put, they want easy money. Politicians, especially President Bush, want to use the Fed's money to buy votes. Traders naturally want a quick profit.
Traders got their wish last week when the Fed cut the discount rate by a half point to 3 percent. Bond prices moved higher in knee-jerk fashion, but the exchange value of the dollar slipped.
Investors should beware. External and internal prices of dollar-based assets cannot move in opposite directions for long. The threat of future inflation implicit in the Fed's move is obvious. Thus, the current rally in bond prices will likely be short-lived, as was its analogue six months ago. Further ahead, the Fed will eventually have to close its money faucet. When it does, the equity market will suffer.
The Fed is adept at manipulating short-term rates, but it has little control over long rates, which are critical to investment decisions. In order to push short-term rates down, the Fed must pump up the money supply. Such actions always backfire. They fan the fear of inflation and drive up the cost of long-term credit. Higher long rates would abort the recovery in homebuilding, which has already slowed.
The Fed acted after the Labor Department reported a seasonally adjusted drop in nonfarm payroll jobs of 117,000. Private employers did not actually cut their payrolls last month. In fact, the number of jobs increased 715,000. However, this was less than "normal." Therefore, seasonally adjusted, jobs were down.
Despite the soggy figures, the recovery is not dead. Special factors help account for slow growth in jobs. Teenagers are 4.4 percent of total employment. Yet they made up more than half the jump in unemployment in May and June. The hike in the minimum wage in 1989 and 1990 has deprived more than 1 million young people of jobs.
Adult jobs, meanwhile, did well. Last month 112.4 million people 20 and older had jobs, up 109,000 from May, and up 1.1 million from the low in November 1991. The number of people with full-time jobs declined in June following six consecutive monthly gains. Even with this drop, full-time employment last month was 853,000 higher than November, a 1.5 percent annual rate of increase. The crucial issue is whether the Fed can promote sustainable, long-run growth by flooding the economy with cash. The answer i s "No." To paraphrase Jerry Jordan, president of the Federal Reserve Bank of Cleveland, monetary policy cannot produce real goods and services. It cannot create jobs. It cannot peg the rate of unemployment or the real rate of interest. What the Fed can do is create a setting of long-term price stability within which the economy will operate most efficiently.
Sadly, the Federal Reserve itself has created an opposite impression among market participants. Traders are now "conditioned," as Mr. Jordan put it, to expect the Federal Reserve to cut interest rates following reports suggesting a weak economy. "The most notorious indicator," he said, "is the monthly unemployment rate, or its companion report, nonfarm employment." To reduce short rates, the Fed must run its electronic printing press overtime to increase the supply of bank reserves, the high-powered fund s that are raw material for the money supply. Over the past nine months, total reserves have increased by almost $10 billion.
As a result, the economy is awash with liquidity. Nonfinancial companies, normally large users of credit, are now lending more than they are borrowing. Consumer purchases of cars and light trucks rose this spring, even though consumer credit declined. Somebody has money.
Fed chairman Alan Greenspan is well aware that fear of inflation is keeping long-term interest rates high. Mr. Greenspan claims inflation will not reemerge, and therefore that long-term bond rates will soon fall. To validate his forecast, Greenspan should declare his independence from the White House, and resist the pressure to cut short-term rates.