By Perry, George L.
Brookings Review , Vol. 12, No. 3
In mid-May the Federal Reserve's open market committee raised the federal funds rate by 1/2 point to 4 1/4 percent, bringing the total increase to 1 1/4 points since it first started tightening policy in early February. Significantly, the Fed said that, with this latest increase, it had removed the monetary accommodation of 1993. Translating from the Delphic language that central bankers favor, this appears to mean it has raised the funds rate as much as it intends to in light of present economic conditions.
This latest decision was taken against an unusual background in financial markets. Most surprisingly, market interest rates of longer maturities--including long-term rates on bonds and mortgages as well as rates on debt instruments maturing in one or two years--had risen substantially more than the 3/4 percentage point by which the Fed had raised the federal funds rate before its latest increase. Measured from their October lows, many market rates had risen twice as much as the funds rate. Historically, by contrast, long-term rates have typically moved much less than the federal funds rate in response to countercyclical moves in monetary policy.
This unusual behavior of market rates relative to Fed actions raises the dual issues of how the Fed should guide and be guided by the markets. On the first, it is clear that Fed policymakers need to consider how their actions are likely to affect market rates, since it is those rates that most directly impact the economy. Indeed, as the Fed was meeting to make its latest federal funds rate move, the large recent increases in market rates were already exerting a restraint on the economy equivalent to more than the 3/4 point by which the Fed had raised the funds rate.
On the second issue, Fed policymakers should be wary of looking at markets as a source of information about what policy actions to take. Markets process information about the economy, including the likely responses of policymakers, and reflect it in prices. But the prices reflect noise along with the information, and they are subject to excessive swings from trend-following market participants.
Just how excessive those price swings can be was demonstrated when the 30-year bond rate was pushed down to 5 3/4 percent last fall, only months before being pulled up to 7 3/4 percent this spring. One common explanation for the increase in rates is that the market was anticipating substantially faster inflation. …