Academic journal article Economic Commentary (Cleveland)

Monetary Policy: An Interpretation of 1994, a Challenge for 1995

Academic journal article Economic Commentary (Cleveland)

Monetary Policy: An Interpretation of 1994, a Challenge for 1995

Article excerpt

In the realm of monetary policy, 1994 was an event year. In February, the central bank's Federal Open Market Committee (FOMC) engineered the first of what would eventually number six increases in the closely watched federal funds rate -- the interest rate that banks charge each other for overnight loans.(1) In contrast to 1993, a year characterized by remarkable stability in short-term interest rates, these actions culminated in federal funds rates that, by year-end, matched levels not seen since 1989.

What should be made of this experience? The professional punditry speaks clearly on this subject: Economic activity in 1994, as measured by the annual growth rate of real GDP, attained a level not enjoyed in this country since the Reagan era. In the minds of the inflation-fearful Federal Reserve, such growth must be restrained, lest price pressures boil over. Hence, it is asserted, in 1994 the FOMC embarked on a campaign of ever higher interest rates, and ever "tighter" monetary policy, to slow the pace of economic activity.

To most people, this is strange behavior indeed. It seems to contradict the publicly stated mission of the FOMC to ensure "maximum sustainable growth by pursuing and ultimately achieving a stable price level."(2) How can the pursuit of price stability be inconsistent with, and simultaneously promote, economic growth?

My response stresses two essential points: First, the level of interest rates is, in general, a poor indicator of the stance of monetary policy. Most, if not all, of last year's rise in the federal funds rate has been inappropriately characterized as monetary tightening. Second, commentary on recent FOMC actions fails to distinguish the relationship between inflation and economic growth in the short run from that which might exist in the long run.

Although this second point has long been fodder for debate among economists, its import is far more than academic. The widely held belief that the monetary authority must fight economic growth in order to combat inflation results directly from the fact that the Federal Reserve lacks a concrete long-run mandate to protect the purchasing power of money. Indeed, I argue here that the absence of a clear objective can force a monetary authority to focus unduly on short-run fluctuations in prices and output that are unimportant in the long run and largely uncontrollable in the short run. At best, this orientation reduces clarity of purpose. At worst, it fundamentally compromises the ultimate mission of monetary policy.

* Interest Rates in 1994: A Real Explanation

Why were interest rates higher at the beginning of 1995 than they were at the beginning of 1994? Connoisseurs of conventional wisdom might recognize this straightforward story: Interest rates rose over the course of 1494 because that's what the Fed wanted. Although appealing in its simplicity, this claim misconstrues the Fed's role in interest-rate determination and ignores compelling developments in the real economy that offer a nonmonetary explanation for the events of last year.

To make the argument concrete, think first of a market for a familiar good, say apples. Little confusion or controversy surrounds the determination of prices in this market -- when the demand for apples rises or the supply decreases, the price of apples goes up.

Thinking in tens of simple supply and demand is useful because an interest rate, after all, is just a price. Specifically, market interest rates represent the price that borrowers pay, and lenders receive, for loanable funds. Just as the price of apples rises when the demand for apples increases, interest rates tend to rise when the demand for borrowing increases.

This scenario -- a rising demand for credit leading to higher interest rates -- provides a good description of the economy over the past two years. Near the beginning of 1993, household saving rates reversed a nearly three-year upward trend. …

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