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Backstopping the Economy Too Well?
Some critics say Fed Chairman Alan Greenspan's very success managing the economy has pushed people into riskier behavior.
(By Larry Downing -- Reuters)
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By June 2003, Fed officials had slashed their benchmark short-term rate to a four-decade low of 1 percent. They held it there for a year, encouraging consumers to keep spending. The cuts worked, helping keep the recession short and mild, supporting an initially weak recovery and preventing deflation. By last June, the economy no longer needed the stimulus of low rates, and the Fed started moving its benchmark short-term rate upward.
Over the past year, the Fed has raised the federal funds rate, the overnight rate charged between banks, to 3 percent in a series of eight hikes of one-quarter percentage point each. Fed officials are likely to move it up again at their meeting today, to 3.25 percent, and to keep pushing it higher in coming months to keep inflation contained.
Fed officials also are likely to repeat, as they have for more than a year, that they probably will keep raising the rate at a "measured" pace. While they emphasize that they could slow or pick up the pace as necessary, investors have come to think "measured" means no more than a quarter-percentage-point increase per scheduled meeting.
Many economists believe the Fed's strategy over the past year has succeeded, enabling financial markets to adjust gradually to rising interest rates with none of the turmoil of 1994-95, when the Fed raised rates higher and faster, contributing to Orange County, Calif.'s bankruptcy, Mexico's currency crisis and the demise of investment bank Kidder Peabody & Co.
"Let's give the Fed credit, they've done a phenomenal job," said Mickey Levy, chief economist for Bank of America Corp. "The economy is sound fundamentally and inflation is low."
However, the fed funds rate remains relatively low for an economy expanding briskly. Too low for critics like Morgan Stanley chief economist Stephen S. Roach, who argued recently that the Fed may have to raise the rate as high as 5.5 percent to wring out "the excesses that now exist."
And AEI's Makin said the Fed should shake the markets out of complacency by dropping its forecast of "measured" rate increases.
Fed board member Donald L. Kohn noted recently that some observers "think our words have removed too much uncertainty from markets, encouraging people to take financial positions that they will regret eventually." But he disagreed, saying, "I believe the performance of the economy, rather than our words, has shaped expectations beyond the very near term."
Kohn added a warning: "Market participants should understand the nature of the chances they are taking. . . . We central bankers are by nature a gloomy lot, trained to focus on what could go wrong; avoiding really bad outcomes helps to shape our policy, and a dose of central banker-like risk assessment is also good advice for investors."
