Fed as God?
From the Wall Street Journal (Sept. 29, 1998)
Alan Greenspan Isn't God
The Federal Open Market Committee convenes today to resume the work of manipulating the federal-funds rate. This procedure is one of the most ill-conceived exercises in the history of price controls. Yet, as the boom of the 1990s attests, it is also one of the most popular.
For those who do not make their living on Wall Street, the funds rate is the cost of a wholesale loan. Controlling this interest rate is how the Fed conducts its monetary policy. A lower funds rate constitutes an easier, or more expansive, policy; a higher rate means a tighter one. Today, at 5.5%, the rate is the highest point along the spectrum of market-determined government securities yields, up to and including the 30-year bond. Either the Fed's interest rate is out of line, or the market's interest rates are.
People endlessly debate at what level the funds rate should be set. However, with the notable exception of the independent financial analyst Bert Ely, almost nobody bothers to ask why it should be set at all. The price of corn, for example, isn't "set." It is "discovered" in the melee of the Chicago futures pits. It is the impersonal forces of supply and demand that determine most prices and yields. Yet, for reasons rarely discussed, the key short-term money market interest rate is determined by a select committee of federal employees.
Nobody can claim that there isn't a money market that could take the job off the government's hands. Trading in dollar-denominated interest-rate futures is vast and deep. In Chicago alone, a half-trillion dollars worth of money-market futures contracts can change hands on a single day. And when Chicagoans turn in for the night, trading follows the sun to Tokyo and London.
It will be said that the money market really isn't free but rather a mirror to the collective expectation of future Fed policy. Certainly, money-market futures prices take their lead from what Chairman Alan Greenspan says. But this doesn't explain why the Fed is presumed to know more than the market. Societies developed markets precisely because the future is unpredictable. What kings and committees couldn't know, markets could find out.
The central bank itself has conceded the germ of this argument. A pair of senior Fed officials, governor Laurence H. Meyer and J. Alfred Broaddus Jr., president of the Richmond, Va., Fed, advocate a plan to enlist the marketplace in the work of bank regulation. The idea is that the safety and soundness of a bank can be inferred from the market value of its debt securities. It is less intrusive to observe the trading patterns of a bank's bonds than to audit its books, Messrs. Meyer and Broaddus have observed. The same train of logic could be applied to interest rates. Markets, although fallible, divine information.
Some contend that the anchor interest rate of U.S. debt markets is too important to be left in private hands. The Fed must control something, the argument goes--if not the price of money, then the quantity. But--alas!--the supply of money is hard to define and measure. That makes it hard to control, as the Fed realized in the early 1980s, when it gave up trying.
One of the greatest bull markets of the past decade and a half has been the bull market in central banking. In the industrialized countries, people have come to trust in managed currencies and in the people who manage them (not to mention in the bonds denominated in them). Markets scoffed when, almost 20 years ago, Paul A. Volcker, newly installed as chairman of a seemingly impotent Fed, vowed to whip inflation. Today Mr. Volcker's successor would be made a saint if Wall Street could canonize him. The dollar-denominated gold price, which topped $800 an ounce in 1980 in a massive, if temporary, vote of no confidence in Mr. Volcker, today stands near a generation low. Long-dated government bond prices are at a generation high.
Deep down, Mr. Greenspan must be embarrassed by his own admiring press. A thoughtful man, he must understand what the central bank can't possibly know. He sees that, in a deregulated economy, the train of causation between a change in the funds rate and the rate of price inflation is, and must be, circuitous. Likewise, he is well aware that the dollar's foreign-exchange value is determined in markets over which he has no direct control.
Not least, Mr. Greenspan must see how vast is the central bank's capacity to do harm. A government-set interest rate is sometimes too low, sometimes too high (and sometimes--let's be fair--it is just right). A too-low federal-funds rate is the kind of rate overwhelmingly favored on Wall Street--in effect, a financial subsidy. A too-high rate, on the other hand, eventually causes business activity to grind to a halt. By missing its mark, a central bank becomes a source of destabilization and a cause of boom and bust.
What to do now? Plainly, the funds rate is an outlier. Fixed more than a percentage point above the three-month Treasury bill, it would be appropriate for a monetary policy aimed at combating inflation. As there is no inflation to speak of--rather the opposite--the rate should be cut.
However, there is a rub. The kind of inflation that does exist, and has existed, is the inflation of investment assets. This kind of inflation can be directly traced to the interest-rate policy of the early 1990s. Then, you will remember, the Fed suppressed the funds rate to help the economy recover from a recession and the debt predicament that had come before. This stimulus had an unintended consequence: It brought forth the boom of the 1990s. Many wholesome forces propelled the great prosperity, along with one key, unwholesome force: the systematic mispricing of credit. For years, so-called risk rates were been pushed closer and closer to Treasury rates. Bankers competed to lend. The junk bond market welcomed companies that had a business plan but did not have actual revenues. In the back of their minds, the creditors seemed to believe that they lived in a new era.
What's not to like about a boom belatedly became apparent. Bargain-basement interest rates induced an extra burst of investment activity. On Main Street, business people built the marginal coffee bar or semiconductor plant. On Wall Street, the marginal hedge fund purchased the extra $50 billion of debt securities (with borrowed money, of course). Everything was fine until it began to dawn on the lenders that the loans, when called, might not come.
Inevitably, the expansion phase of the credit cycle has given way to the contraction phase. At the margin, world-wide, bankers have rediscovered how to say no. No doubt the Fed would like them to continue saying yes, at least for the time being. But what can the FOMC do? Throw a lifeline to Wall Street in the form of a lower funds rate? Risk a financial disaster by continuing to hold the funds rate at such a big premium to the structure of market-determined rates?
Gradually--inexorably--the Fed has become the regulator of speculative booms. By helping engineer the roaring 1990s, it now bears the blame for the inevitable losses. Mr. Greenspan should acknowledge the scrape he's in. He should begin a public discussion about the weaknesses inherent in the Fed's operating method. To disabuse investors of any residual misplaced faith they may have in him, he should acknowledge that he is only a federal employee--a mere mortal.
Mr. Grant is the editor of Grant's Interest Rate Observer.
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