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Has the Federal Reserve Overdone It?

J. Bradford DeLong

For nearly a full decade the luck of Alan Greenspan and his interest rate-setting Federal Open Market Committee has been astonishing (and their skill has been astonishing too). Their luck and skill, combined with the elimination of the federal budget deficit that has boosted investment and combined with the computer and communications revolutions in technology that have boosted total factor productivity growth, have given the American economy an amazing decade.

But now for the first time since the recession of 1990 there are signs that the phenomenal juggling act may be over--and that a ball may be dropped. For the first time in ten years there are enough danger signs that it actually makes sense to worry about a recession here in the United States.

It has been a long time since we have seriously worried about the prospect of a real economic downturn. In fact, as far as monetary policy is concerned, the American economy has had an amazing run not for one but for nearly two decades. It is true that overall productivity growth in America was slow during the 1980s (perhaps because of the high federal deficit, perhaps because of adjustment to then-high oil prices, more likely for a combination of these and other reasons). But since the end of the last big recession in 1983, it is very hard to fault the Federal Reserve for anything. From 1983 to 1987 under Paul Volcker the Federal Reserve guided the economy to a rapid recovery without reigniting the inflation of the 1970s.

In the early years of Alan Greenspan's term the Federal Reserve moved aggressively to make sure the stock market crash of 1987 did not raise unemployment--thus trading the risk of a large recession soon for the risk of slightly higher inflation later. In my view this was a good trade. You can say--correctly--that the Federal Reserve's concern about the possible consequences of the 1987 stock market crash planted the seeds of the uptick in inflation in 1989-1990 and the recession of 1990-1991. But given the balance of risks it is extremely hard to fault the Federal Reserve.

Moreover, the Federal Reserve moved aggressively at the start of the 1990s to make sure that little recession remained little. Then came the amazing performance of the 1990s. In the first half of the decade the Greenspan-led Federal Reserve held interest rates low to make sure that deficit reduction did not depress aggregate demand. In the second half it let unemployment rates drift down to a level--four percent--that everyone at the start of the decade would have regarded as imprudent. And it made the right decision both times.

Two and a half years ago the Federal Reserve was worried about the state of the world financial system. The East Asian financial crisis, the Russian default, and the squeeze-out of Long Term Capital Management led the Federal Reserve to cut interest rates by a full percentage point in the fall of 1998. But the crisis soon passed. Since then, for the past two years, the Federal Reserve has been raising interest rates. It has been trying to curb possible future inflation without sending the economy into a recession. And there are now, for the first time in a decade, significant signs that it has overdone it.

In the past two years the Federal Reserve has raised the nominal interest rate on three-month Treasury bills by two percent to the 6.25% of today. This has created one of the standard signs of an approaching recession: an inverted yield curve. The interest rate on ten and thirty-year Treasury bonds is now higher than the interest rate on three-month Treasury bill, inverting the normal pattern in which short-term interest rates are lower than long-term ones.

In the past few months this pattern of rising interest rates has been accompanied by a sharp slowdown in U.S. economic growth: real GDP that grew at a five percent annual rate in the first half of the year looks to grow at three percent or so per year in the second half. In the first half of the year the (seasonally adjusted) economy created 1.6 million nonfarm jobs. In the second half of the year it looks as though the (seasonally adjusted) economy will create only 350 thousand nonfarm jobs.

The stock market has been stagnant this year. In past years increasing stock market wealth has pushed the economy forward by igniting an enormous consumer spending boom. It is difficult to see such high rates of consumer spending out of stock market wealth sustained if the market turns from bull to bear. And Yale Professor Robert Shiller's arguments in his book _Irrational Exuberance_ that we are due for a very large bear market are convincing, and sobering.

Moreover, much of the increase in interest rates has not had time to affect the state of the economy. The rule of thumb is that it takes a year (or a little more) for increases in interest rates to affect production and income, a little longer to affect employment, and still longer to affect the rate of inflation. Roughly half of the interest rate increases since the end of 1998 have yet to affect the economy.

Before our next recession comes (if it comes), we should reflect not on our bad but on our good economic luck: we should remember that what is truly remarkable is that we have had so long a run without any significant downturn in production and employment. But these three factors--today's inverted yield curve, the sharp slowdown in growth, and the fact that half the interest rate increases of the past two years are "still in the pipeline"--make a recession in the next two years possible, and perhaps even likely.

Perhaps the current level of interest rates will turn out to be appropriate. It is true that half of the interest rate increases over the past two years are still inside the pipeline, and have not yet had a chance to affect the economy. But the underlying strength of growth may surprise us yet again.

However, that does not seem to be the way to bet. It is well known that the committee-consensus structure of decision making at the Federal Reserve creates a tendency to fall behind the curve. Committees that move by consensus need to provide polite opportunities for members who have crawled out onto weak limbs to crawl back. They need to defer action for a meeting or two to satisfy members who want to wait and see, even if everyone else has already waited long enough and seen enough. Former Federal Reserve Vice Chair Alan Blinder points out in his _Central Banking in Theory and Practice_ that this committee decision-making structure has substantial counterbalancing advantages. But it does leave us with an institution that has difficulty reversing course rapidly.

Thus at this moment it is not at all clear what the Federal Reserve should do. The slowing of the economy suggests that we would be in a better position today if the last two or three most recent interest rate increases had never happened. But a sudden reduction of interest rates this winter would be a sharp departure from typical patterns of Federal Reserve policy. How would the markets read such a departure? If there is one axiom of policy on which everyone agrees, it is that financial markets dislike big surprises.

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Do you have a perspective to offer? Please contribute it. If the web does change the world, it will do so only by increasing the bandwidth of communication--by automatically combining the intelligent thoughts of many people. Eric Raymond has claimed that as far as writing software is concerned, "with enough eyeballs, all bugs are shallow." It may be true for the rest of human endeavor as well...

I've just finished reading your article in Fortune Magazine Dec. 2000
(Has the Federal Reserve Overdone It?). As this was written a few months ago,
I'm wondering what you think of Wednesday's sudden interest rate drop
of .5%. Do you think this will halt the threat of recession or do you
still think, as you mentioned at the end of the article, that it will
only create "more shocks to come"?

Thank you and I enjoyed you article very much.


Contributed by Elaine See <> on January 10, 2001

I was surprised by the move: I wasn't expecting it.

I think it probably indicates that Alan Greenspan saw something in the Christmas sales numbers that scared him, and that the threat of recession is much greater than I thought it was...

Contributed by Brad DeLong <> on January 10, 2001

Professor of Economics J. Bradford DeLong, 601 Evans Hall, #3880
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax

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