The pause that might not refresh: Tuesday, for the first time in two years, the Federal Reserve didn't raise interest rates -- but is the damage already done?
By Brad DeLong
Aug. 08, 2006 | Shortly before 2:15 p.m. Eastern time Tuesday, after a meeting in Washington that nearly every American would've found mind-numbingly dull, someone made a phone call to the Federal Reserve Bank in New York. The purpose of the phone call was to tell the bank's trading desk that the Federal Reserve's Federal Open Market Committee, known as the FOMC, had decided that the level of bond prices -- specifically, the price of three-month Treasury bills: promises by the U.S. Treasury to pay cash in three months -- was just right.
The price didn't need to be raised or lowered to be consistent with price stability and with maximum employment, purchasing power and growth. The FOMC told the trading desk to buy and sell some of its three-month Treasury bills to keep their price stable, and thus keep the interest rate the Treasury bills would earn stable: 5.25 percent. This is the first time in two years (and 18 meetings -- the meetings are held every month and a half) that the FOMC has not raised interest rates, which have climbed 4.25 percentage points since the spring of 2004.
From one perspective these FOMC decisions are trivial and tiny. As a result of this phone call, the trading desk at the Federal Reserve Bank will buy or sell a few extra billion dollars in bonds, far less than $100 worth for each person in the United States. Banks and other financial institutions will have a little more or less cash, and a little fewer or more bonds, but the proportion of cash and bonds in their portfolios will change by what seem to be insignificant amounts.
Yet such relatively small actions by the Federal Reserve's FOMC affect every single bond price and interest rate in the entire world. Traders on Wall Street are now revising their expectations about the future path of interest rates.
When the FOMC raises interest rates, as many expected would happen Tuesday, corporations tend to borrow a little bit less than they would have otherwise, spend a little bit less on new factories and equipment, and so hire fewer people. Construction companies borrow a little bit less, spend a little bit less building houses, and so hire fewer people. The slightly higher interest rates lead a few households to decide not to take out that home equity loan after all. Those households spend less, so the businesses that supply what they buy hire fewer people.
The chain of decisions triggered by raising interest rates is costly. Unemployment would be a little bit higher if the FOMC had raised interest rates today: By November 2007 there would probably be an extra 250,000 Americans unemployed. That's why the FOMC didn't do it. That's why the FOMC stood pat and kept bond prices and interest rates constant Tuesday.
But raising interest rates would have had benefits as well. Lower demand lowers inflation. Because the FOMC didn't raise interest rates this time, by November 2007 inflation will probably be higher by about 0.1 percent per year. If you believe -- as the FOMC does, with a faith so strong that St. Paul would marvel at it -- that the economy works much better if prices are roughly stable, with lower average unemployment and faster growth, then that creep-up of inflation is not something that should be allowed to continue indefinitely.
Every economist in the world wishes Federal Reserve chairman Ben Bernanke and his team at the FOMC well. We all hope that he makes the right decisions, even when we disagree with him. We would prefer that his decisions be right and our judgments be wrong rather than his decisions be wrong and our judgments be right. But we all have our views, and so the FOMC's meetings every month and a half are surrounded by a chorus of commentary from economists, each of them saying what he or she thinks the FOMC should do.
For the Federal Reserve is trying to hit the sweet spot. It would be bad if inflationary pressures returned to the levels they were in the 1970s, and growth slowed as people became confused about which prices were rising because goods were in short supply and which prices were rising simply because the Federal Reserve had pumped too much cash into the economy by keeping bond prices too high and interest rates too low. It would be bad if the Federal Reserve pushed bond prices too low and interest rates too high and then discovered that it had pushed unemployment higher as well.
Some think that the FOMC has already raised interest rates too high. They see an economy in which the principal danger is not that inflationary pressures are gathering but that spending is already falling. Dean Baker of the Center for Economic and Policy Research notices rapid increases in credit-card debt outstanding in May and June, and fears that this is a sign that past FOMC interest rate increases are already shutting down the home-equity ATM, and that households that can no longer borrow attractively against home equity are maxing out their credit cards. If that's true, they will be forced to cut back on the consumer spending that has fueled so much of the current business cycle expansion. The economy is still growing now, but Baker and others think that's because a lot of the consequences of the past two years of interest rate increases have not yet had their full effect. These increases are still "in the pipeline," and come November 2007, according to this point of view, we will all be glad that that the FOMC did not raise interest rates Tuesday.
On the other side, Marty Feldstein of Harvard, president of the National Bureau of Economic Research, and former chairman of the President's Council of Economic Advisors under Ronald Reagan, believes that the Federal Reserve must "convince the markets that inflation will be contained" as successfully under the stewardship of Bernanke as it was under Alan Greenspan, and as a result the FOMC "must show that it is willing to take the risk of tightening [interest rates] too much." But John Berry (who used to make the Washington Post's coverage of the Federal Reserve the most sophisticated of all daily newspapers before he jumped to Bloomberg) judges that the markets expect a pause, and that there will not "be much of a backlash from analysts wringing their hands about Fed Chairman Ben S. Bernanke being 'soft on inflation' or about the loss of Fed credibility as an inflation fighter. After all, a pause would be just that."
Feldstein recognizes that uncertainty is immense, and that he could well be wrong in his judgment that inflationary pressures are the major risk to be guarded against: "The consequences of the past [two years' worth of] interest rate hikes are difficult to predict ... [a] fall in house prices; residential construction plummet[ing] …; lower housing wealth; [a] sharp fall in mortgage refinancing, bringing down consumer spending, expenditures on equipment and software slow[ing] sharply … A much sharper slowdown than the central tendency forecasts is certainly possible."
This uncertainty is the reason that the FOMC is feeling its way month by month, moving interest rates in small, bite-sized quarter-percent increments, and warning everyone that it does not know what it is going to do next. The FOMC calls its decisions "data dependent," and the committee members know the stakes and risk and the magnitude of uncertainty as well as anyone.
From one perspective this looks like witchcraft: a group of people in a room pulling and pushing metaphorical levers when they are not sure how strongly these levers are attached to anything.
From another perspective this is a triumph of technocracy. Trained professionals are trying their best to socially engineer a healthy and productive economy. They're thinking and making decisions at a level of detail and sophistication that not one person in a thousand can follow, and yet those decisions have a powerful impact on all of us.
-- By Brad DeLong