The Economy

Dec. 21, 2004
Rate hikes won't dampen economy.

The Fed has now raised the federal funds rate four times in the last eight months, and is poised to raise it at least twice more later this year. Yet the economy continues to exhibit runaway growth. Doesn't monetary policy matter anymore? Even during the mid-1990s there was some evidence that changes in interest rates did not have the same impact on real growth as was once the case. During 1994 short-term rates rose three percentage points and long-term rates rose two points; yet the following year, the growth rate fell only 1.3 percentage points, from 4.0% to 2.7%. The old rule of thumb had been that a one percentage point rise in interest rates reduced the real growth rate by one point the following year. By comparison, the 1990-91 recession was marked not only by rising interest rates, but also by an inverted yield curve and a cutback in credit driven by the reaction to the savings and loan scandals. The pattern of the economy during recessions reinforces the conclusion that the availability of credit has an even greater impact on real growth than the cost of credit. While both factors have been important, higher rates have usually occurred simultaneously with tighter credit. By comparison, there has been no cutback in credit availability over the past year in spite of the substantial increase in interest rates. While there is no one perfect measure of credit availability, in the past the yield spread has been the most useful indicator. During 1994, the yield spread narrowed by about one percentage point, close to the 1.3 point drop in real GDP the following year. By comparison, the yield spread has widened about one-half percentage point over the past year, which will help offset the negative influence of higher interest rates on real growth this year. Alan Greenspan is actually the first Fed chairman to successfully keep the federal funds rate near its equilibrium value. From 1949 through 1969, when William McChesney Martin was chairman, his attempt to implement a countercyclical policy was in large part responsible for the five recessions during his stewardship. Arthur Burns kept the funds rate below equilibrium, with the result that double-digit inflation surfaced twice in the 1970s. Paul Volcker, in his determination to eliminate inflation, kept the funds rate so high that real growth was stunted, with an average growth in productivity of only 1.1% during his two terms. Of course many would claim Volcker had little choice, given runaway inflation and the huge budget deficits, yet the fact remains that the funds rate did average more than five percentage points above the inflation rate during the years when he was chairman. I expect the funds rate to rise to 6.5% over the course of the year, but I don't expect it to slow down the economy. My forecast of 4.1% growth for 2000 is higher than other economists, but that's because I see monetary policy keeping inflationary expectations in bounds without restricting the supply of credit. Admittedly this balancing act is somewhat simpler now that the federal budget is in surplus, but no other Fed chairman was able to accomplish the goal of managing monetary policy to generate rapid growth at full employment with low, stable inflation. It makes no sense to argue that Fed policy has become irrelevant; the Fed, if it wanted, could always cause a recession. But of course it has no reason to visit that sort of punishment on the economy as long as inflation remains stable, no matter how fast real GDP increases. Thus, further modest increases in interest rates this year will keep the growth rate constant instead of lower it, as long as inflation does not get out of hand. With productivity rising almost 3% per year and wage rates continuing to rise about 4%, there is virtually no chance of accelerating inflation. The big gains in the inflation rate in January due to higher oil prices will be fully offset in the spring and summer months. Consequently, as long as the supply of credit is not tightened, the economy should continue to grow at a 4% rate in spite of gradually rising interest rates. Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill. His e-mail address is [email protected].

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