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Commentary | PERSPECTIVE ON THE ECONOMY

Fed Wisely Issues a Heads-Up

Signaling an interest rate boost later this year was smart, given global and domestic considerations.

May 20, 1999|ROSS DeVOL | Ross DeVol is director of regional and demographic studies for the Milken Institute, a Santa Monica-based economic think tank. The opinions expressed here are his own

In the spirit of the Federal Reserve's newly discovered policy openness, it announced on Tuesday the adoption of a "tightening bias." This is Fed-speak for signaling that it will likely raise interest rates sometime over the next six months.

Many Californians and the rest of the country are wondering why the Fed is considering raising interest rates at a time of economic prosperity with low inflation. In other words, why would the Fed steal the punch bowl?

To understand the Fed's bias toward raising interest rates--and to understand why raising interest rates is the appropriate policy prescription for the U.S. economy--we must look at the reasons for the Fed's three interest rate cuts last fall.

The Asian economic and financial crisis began in July 1997 as currencies and stock markets plummeted throughout the region. The turmoil spread to Russia, Latin America and other emerging markets last fall and threatened to engulf the world economy. In an attempt to prevent a catastrophic outcome in the global economy, the Fed cut interest rates three-quarters of a point to ensure that the U.S. economy would remain a locomotive for growth for the rest of the world. This was the first time in the history of the Federal Reserve's monetary policy deliberations that international considerations were elevated above domestic considerations.

In the spring and summer of last year, the Fed was contemplating an upward move in interest rates, fearing an overheated U.S. economy. If the Fed had not been heavily weighing Asian, Brazilian and other emerging markets' concerns, it would likely have taken a preemptive strike against rising inflation risks. The published minutes of the June 30 and July 1 Federal Open Market Committee meeting state: "Because there did not seem to be any urgency to tighten current policy for domestic reasons, given the likelihood that inflation would remain subdued for a while, important weight should be given to potential reactions abroad."

Whether Fed Chairman Alan Greenspan seeks to be or not, he is currently the world's central banker and will likely remain so for the foreseeable future. After the Fed cut interest rates last fall, central banks around the globe followed Greenspan's lead by cutting interest rates more than 100 times. These cuts in interest rates helped provide liquidity to global financial markets and reduce the spread between U.S. treasuries and other debt instruments. Without these cuts in interest rates, a truly global financial and economic meltdown was possible.

Recent readings show that the worst is probably over for the economies of Asia and Latin America, or, at least, that the risks of a global recession are receding. Nevertheless, the economic recoveries are tenuous and fragile in both Asia and Latin America. This is the dilemma that the Fed faces: While domestic considerations probably warrant it, if it tightens too quickly it might risk derailing incipient recoveries abroad. Since the Fed cut interest rates, real GDP growth in the U.S. has averaged more than 5%, far in excess of what any respected economist believes is sustainable. The Federal Reserve's job is to be preemptive and vigilant against inflationary tendencies developing in the U.S. economy. As former Federal Reserve Chairman Paul Volcker recently stated: "I made a career out of worrying about inflation."

There are other global concerns for the U.S. economy. Because our economic growth has been strong and Asia has been in recession, our trade imbalance is growing rapidly. In the short term, this does not pose a severe problem, but at some point it could become one. Foreigners may decide that they do not want to hold so many dollars and dump them. Increasing the supply of dollars by such a large amount could cause the value of the dollar to tumble.

The Fed's newfound policy of openness is appropriate in an information age economy. If the Fed were to move from cutting interest rates to raising them without first signaling its intention, the financial markets might overreact.

In weighing global and domestic considerations, the Fed wisely smoothed the way to raise interest rates modestly in the second half of 1999. A little dose of preventive medication over the next few months should avoid monetary policy surgery later, helping to sustain our long-term economic prosperity.

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