February 27, 2002

Fed would do well to lighten up a little on economic gas pedal

By James W. Coons

When Federal Reserve Chairman Alan Greenspan testifies on monetary policy before Congress on Wednesday, he should prepare the markets for increases in the interest rate controlled by the Fed.

The Fed did the right thing a year ago to reduce rates as the economy weakened. And monetary policy makers once again stemmed crisis with well-timed actions late last summer and fall. But the economy has stabilized and started to improve. In some respects, activity hardly missed a beat during what appears to have been the mildest recession ever.

After shrinking during the third quarter, the economy eked out a small gain in the fourth. The latest reports indicate that the increase will be revised up to as high as 1%. Some analysts think that the economy will expand by as much as 3% at an annual rate this quarter.

The January decline in total employment was the smallest since August. The unemployment rate improved for the first time since last May. Judging from the downward trend in the number of workers filing initial claims for unemployment benefits, employment might start increasing this month or next. While businesses are not yet hiring in a big way, job losses have slowed significantly.

These fledgling improvements in the labor market have already lifted consumer confidence. Surveys of consumer attitudes are well off their lows, and spending has been stronger than anticipated. Core retail sales jumped 1% and discretionary sales rose 0.7% in January. Both increases came on top of large upward revisions to previous months.

The production side of the economy is starting to turn up, too. Factory output was flat in January, following an almost uninterrupted string of monthly declines stretching back to the summer of 2000. The high-tech sector led the way into recession, and is leading the way out. After sinking from 67% growth over a six-month span in early 2000 to 25% contraction in late 2001, production of computers, communications equipment, and semiconductors is flat with its level six months ago.

Even motor vehicle production is ramping up. Auto inventories slipped to a record low of 50 days of sales at the end of last year. In response, manufacturers boosted first half production schedules. The auto sector could contribute one half percentage point to overall growth in each of the first two quarters.
The Fed lowered short-term interest rates eleven times during the last thirteen months by a total of almost 5 percentage points. The shift came first because the economy was slowing and then in response to the turmoil and uncertainty in financial and product markets. Both of those factors are fading. With them goes the justification for artificially low short-term interest rates.

I am not suggesting that the Fed needs to slam on the breaks to restrain a runaway economy. Far from it. What I am saying is that, now that the economy is clearly on the mend, the Fed should let up a little bit on the accelerator.

There is room for debate about the appropriate level of short-term interest rates in most circumstances. I have researched the issue for years, and my measures are still only rough guides. But it is clear that zero or below is too low for inflation-adjusted rates when the economy is growing.

The Fed lowered its benchmark interest rate to about the same level as inflation last year. At 1.75%, the federal funds rate was only slightly above the 1.1% increase in the consumer price index during the previous twelve months. And that might have been the low-point in inflation for this cycle.

The underlying inflation rate is at least another full percentage point higher. That means that the Fed needs to reverse the 1.75 percentage point emergency reduction made late last summer and fall just to get its rate meaningfully into positive territory on an inflation-adjusted basis.

Raising the federal funds rate to 3.5% by year end will not derail the recovery. If the prospects for the economy really are improving, slightly higher interest rates will not stand in the way. In fact, appropriately sized and timed rate increases now will prevent higher inflation and much higher interest rates later.

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