April 19, 2001

Now that the Federal Reserve has surprised the financial markets with a decline in targeted rates between meetings, two questions arise. First, how much more will short term interest rates decline. Second, will the Federal Reserve return rates to "normal" after sufficient economic stimulus has been provided.

When the Federal Reserve increased interest rate targets in 1994, it mentioned that the banking community no longer needed stimulus. If you remember, banking was seriously stressed even before the 1990 recession began. Only by nationalizing the bad banking debt and then distributing the collateral through a temporarily created government agency was the government able to restore forward looking banking in the United States.

For its part, the Federal Reserve engineered an unusually low short term interest rate relative to long rates to allow banks to earn their way out of their problems. Banks tend to borrow at the short rates and lend at more structured longer term rates. Therefore, this very steep yield curve dramatically increased the earnings of banks.

The combined impact of the bad debt nationalization and the steep yield curve solved the banking problem. (This is a remedy that the Japanese continue to avoid, because it also requires removing the bad previous bank management. The inability of Japanese banks to look past their past errors to new opportunities explains much of the problem with the Japanese economy.)

When the Federal Reserve explained that it was no longer guaranteeing a steep yield curve, it mentioned that "normal" interest rate targets were 1.5 to 2.5 percentage points above the prevailing inflation rate. I see nothing that has intervened to alter that definition of normal.

The latest consumer price index showed increases of 2.9 percent in the past twelve months. With interest rate targets at 4 percent after this latest move, real short term rates are 1.6 percent, or at the low end of normal.

Assuming the Federal Reserve is right in its definition of ''normal", this means that rates will now preserve current conditions. If these current conditions are unacceptable, as I think they are, then rates must fall further adjusted for inflation.

Therefore, I expect another half point reduction in rates when the Federal Reserve meets on May 15. At that point, however, I expect that the Federal Reserve will wait to see if the stimulus is beginning to take hold. Indeed, no further rate reductions may be necessary.

Of course, falling short term rates do not automatically mean that long term rates are falling. Indeed, if bond investors believe current policy will prevent recession and possibly allow more inflation than a recession would generate, then they may sell their long term positions when the Federal Reserve cuts short term rates aggressively.

Also, the Treasury has changed the way it is reducing debt. Last year, the Treasury sought long term instruments with high interest rate coupons. This year, the Treasury is reducing the size of the weekly and monthly auctions. Last year, long term rates fell to the level of short term rates.

As the weekly and monthly auctions are short term instruments, short term rates are falling while long term rates are not benefited by Treasury actions. This adds to the reduction of short term rates and the possibility of rising long term rates from Federal Reserve policy. Do not look for any declines in long term interest rates for the remainder of this year.

Now to the second question. Unfortunately, the Federal Reserve acts as if its work is done when the restraint ard stimulus takes hold. Last year they kept short term interest rates at more than 3 percentage points above inflation even after the speculative stock market bubble had deflated. This contributed to some of our current weakness.

I believe they will err on the other side this time. They will hold interest rates unusually low relative to inflation even after a rebound is well established. This inertia following policy moves leads to greater volatility in the economy than necessary.

If the Federal Reserve had returned to a "normal" interest rate of about 5.5 percent after the stock market began sliding further in September, then the economic weakness we currently are suffering would have been much smaller. If the Federal Reserve preserves the lower interest rates after the economy rebounds late this year, then inflation in the next couple of years may be higher than otherwise would occur.

Hopefully, the Federal Reserve now understands that once the medicine cures the patient, it should no longer be applied. We shall see.


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