Fed's Easing Has Gone Too Far

For the second time in two months, Federal Reserve Chairman Alan Greenspan has surrendered to overwhelming pressure from the White House.

Last week, the Fed cut its discount rate to 4.5%, a 20-year low. The last time the central bank pushed its key lending rate to that level was in December 1971, when Richard Nixon was souping up the economy for the 1972 election. That ploy eventually led to soaring inflation and, ultimately, a deep recession.

By itself, the discount rate has little significance. Banks borrow very little from the Fed.

However, the discount rate is a key signal of the central bank's interest rate policy.

Pumping Money

To push down short-term rates in the credit market during an economic recovery, the Federal Reserve must pump in progressively larger amounts of high-powered money.

The Fed's latest move to reduce rates came as bank reserves were already soaring. Total reserves - the raw material of the money supply - rose at an annual rate of 17% in October. Reserves have increased about 8.5% in the past year. The average annual growth in reserves over the last 45 years was 4.7%.

Under the Fed's current regulations, every added reserve dollar will let banks assume more than $60 of additional liabilities, which makes reserves high-powered money, indeed.

Thus, the $4.7 billion that the Fed added to total bank reserves in the past year would support roughly $250 billion in new loans and investments.

Increases of that size might help Mr. Bush's reelection campaign. However, they are unlikely to provide a basis for noninflationary economic growth.

Advocates of Easing

Wall Street's amateur Fed watchers seem to think that the central bank should try to reduce long-term interest rates by pumping high-powered money into the credit markets.

The typical comment is that long-term rates must drop below 7.75% in order for policymakers to be "comfortable." According to one such "analyst," this will lead to Fed to ease again at the next Open Market Committee meeting, Dec. 17.

Granted that long-term interest rates should come down, the question is how.

The only way to get rates down and, more important, keep them down is through modest and stable growth of high-powered money.

Angell's View

Investors should recognize that the more the White House takes over monetary policy, the greater the inflationary risk. Fed Governor Wayne Angell hinted at such problems last week when he voted against the discount rate cut.

The United States has made "great strides" against inflation, he said. He warned, however, that the rate cut was probably premature. Such cuts should be delayed, he argued, until "they will have maximum impact" in reducing long-term bond yields.

Unless the Fed reverses its easy-money policy within a few weeks, the risk of renewed inflationary pressures in 1993 and 1994 will continue to rise.

Participants in the credit markets will anticipate the coming erosion in the real value of their assets and shorten the effective duration of their portfolios. In turn, this would lead to an increase in long-term interest rates that could threaten the present level of the stock market, the economic recovery, and, of course, Mr. Bush's second term in the White House.

A Warning Fulfilled

Almost two years ago, I warned that serious and growing problems on Wall Street would lead to credit rationing and high real interest rates. I said that, though Mr. Greenspan's commitment against inflation was sincere, an overly tight monetary policy would drive the economy into a deep decline. In that case, I said, the tight money gambit would backfire.

"If the Fed were confronted with a sharp slump in business, surging unemployment, and sagging corporate profits, it would have to reflate," I wrote at the time.

"It has happened before. Given time, it could happen again. Both actual and anticipated rates of inflation would be more likely to rise than fall."

One can't understand the Fed by looking at the fed funds rate.

The Fed manages interest rates by regulating the supply of funds in the money market.

Though the Fed can directly influence the supply of funds, it cannot control the demand for them - at least in the short run. Therefore, to peg short-term rates in a market where demand is highly volatile, traders at the Federal Reserve Bank of New York constantly adjust the supply of funds.

At the moment, with the economy slowly expanding, demand for credit is stable. Thus, the Fed had to add funds in the credit market to push rates down.

This is why total reserves showed such a large increase in October. Because the demand for credit stabilized (a typical sign of recovery), the Fed ended up easing monetary policy to implement a modest change in credit market conditions.

Changes in the growth of the money supply influence business activity after a long lag. The inflationary pressures that worried the Fed from 1987 through 1990 were a result of 17%-plus growth in bank reserves (and 14% growth in the money supply) in 1985 and 1986.

The 1990-91 recession reflected the impact of less than 1% growth in reserves from 1987 through 1990.

Inflation in 1993 and 1994 will reflect the pickup in monetary growth in 1991 and 1992.

Mr. Heinemann is chief economist at Ladenburg. Thalmann & Co., investment bankers in New York.

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