Despite Risks, Fed Should Ease More

Economic policy authorities in the United States face a real conflict between what the economy needs in the short run and what is good over the long run.

In the short run, domestic spending must be stimulated. Over the longer term, the nation's economic health requires restraint in growth of domestic spending and an increase in the savings rate from the 1980s level.

There is no easy way to resolve this conflict. In fact, there is really nothing to do but go ahead and push for more domestic spending now, since the economic slump has already lasted more than long enough.

Renewed Slump Possible

The U.S. economy still seems to be in the trough that followed the recession. We may be on the upward slope, but the slope is slippery.

Real gross national product, essentially flat in the second quarter, grew in the third, mostly because of production increases that went into inventories.

But the rate may well fall back in the fourth quarter.

Help from Abroad

The weak economic performance of the past two quarters stems not only from conditions in the United States but also from policies abroad.

During the worst of the recession, conditions abroad had helped moderate the U.S. slump. Now, they are working against our recovery.

In the fourth quarter of 1990 and the first quarter of 1991, real GNP dropped at an annual rate of about 2.25%. The decline would have been almost twice as steep if not for the sharp improvement in our real net export position.

However, in the two quarters just past, U.S. net exports worsened considerably (even apart from special factors related to oil imports), exerting a substantial drag on growth in domestic output.

On Our Own

Monetary restraint in major foreign economies, such as Germany's and Japan's, has prevented exports from leading us out of the slump. Weak economic conditions in other countries have had the same effect.

All this makes it especially important to stimulate domestic spending in this country.

Clearly, we cannot use the fiscal weapon - at least, not until monetary policy is proved ineffective. And I doubt it will be.

Monetary policy has halted the recession, but it has not propelled a recovery. The deterioration in real net exports has probably been unexpectedly severe, and monetary policy has not encouraged enough domestic spending to significantly offset that deterioration.

More remains to be done.

Fed Must Act

If banks have been cautious in making loans and have raised lending standards, the negative economic effects can be offset by pushing down open-market interest rates further.

The Fed has been fairly active in that regard; evidence is the trend in the narrow money supply, M1, which grew at an annual rate of 7.25% in the first nine months of the year.

However, the Fed's actions have not been sufficiently strong to spread more broadly. M2 grew at an annual rate of only 2.5% in the same period.

It looks as though the overnight money-market rate - the federal funds rate - must be pushed down even closer to the underlying rate of inflation.

And if that did not increase domestic spending, the funds rate might have to be driven temporarily below the inflation rate. However, the acceleration of inflation in the 1970s when short rates were driven so low during recessions is an argument for caution.

A Necessary Risk

In general, the risk in all this is that our short-run need to enhance domestic spending will invite a longer-run problem.

Sooner or later, the economies in the rest of the world will again show real strength. Once that happens, U.S. net exports will stop deteriorating and improve markedly.

If that occurred while domestic spending was gathering momentum, inflationary pressures - which are not as weak as a superficial reading of the third-quarter GNP figure suggests - would reassert themselves.

Interest rates would rise. However, an aggressively easy Fed policy, which is probably necessary now, could well entail a need to let at least short interest rates rise at some point next year.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.