by Archie M. Richards, Jr., CFP^®
January 15, 2001

The speed with which the economic slowdown has occurred is the fault of the Federal Reserve Bank. If the Fed doesn't shape up, recovery could be slow.

The Federal Reserve creates the dollars and cents held in the nation's bank accounts, these making up most of the U.S. money supply. When the Fed chooses to increase the supply, it buys from the public some of the debt securities that had previously been issued by the Treasury Department. It pays for them by arranging for dollar amounts to be credited to the bank accounts of the sellers. New smackers, these are, created out of nothing and available to spend as the sellers choose.

When the Fed wishes to lessen the supply of money, it sells to the public some of the Treasury securities it had previously acquired. The money paid for them disappears.

In this writer's humble opinion, the Fed should produce a steady and predictable supply of money every day. But no, it prefers to exercise discretion in a convoluted manner, using the fed funds money market.

In the fed funds market, banks having more money than they need lend to those that have less than they need. Every day, banks lend money to each other, usually overnight. The interest rate of each loan is set by the two banks involved.

Here's where the Fed comes in. It decides what it thinks the interest rate in the fed funds market should be. When the rate rises above the desired level, the Fed adds new money to the economy. When the rate falls below the desired level, it withdraws money from the economy. Not only does the Fed control most of the nation's money supply, its impact on the fed fund rate influences all short-term interest rates profoundly.

In early-1999, when the desired fed funds rate stood at 4.75 percent, the Fed, foolishly, in my opinion, became concerned that the economy was growing too rapidly and that the stock market was rising too fast. Fearing inflation, the Fed implied to the public that until the growth slowed, it would continue to raise short-term interest rates and restrict the availability of money.

Assume you're a businessman. You plan next year to obtain bank financing to buy an expensive machine. But because of Federal Reserve announcements, you expect interest rates to rise over the next eighteen months. You wouldn't wait until next year. You'd nail down the lower interest rates and save yourself some dough by buying the machine now.

This is what happened in the entire economy. Taking advantage of low interest rates before they rose, businessmen and consumers bought machinery, cars, houses, and everything else. The economy kept on growing rapidly, because people bought things sooner than they otherwise would have. The Fed went on raising the fed funds rate gradually, not realizing that the continuation of rapid growth was caused by its own pronouncements. In the end, it raised the rates too high.

With fed funds at 6.5 percent in mid-2000, the Fed implied that it would raise the rate no further. Soon thereafter, whomp! The economy braked to a halt. People didn't need to buy more. They had already bought more than they needed.

The opposite pattern may well occur now on the downside. If the Fed reduces interest rates gradually, people will delay their purchases to take advantage of lower rates later on. To avoid the economy stagnating for months, the Fed should lower the fed funds rate all at once to the final correct level.

But what is the final correct level?

You ask the perfect question. No one knows, and no one could ever know. Trial-and-error is the only method the Fed dares to use.

The incremental approach sends misleading signals. And the one-shot approach cannot be determined accurately in advance. No matter what the Fed does, it's likely to be wrong. Therefore, the Fed should stop exercising discretion that adversely affects the wellbeing of millions of people. It should quit monkeying around and simply increase the money supply at a steady, predictable rate.

In the meantime, how about moving the fed funds rate back to 4.75 percent? Just a wild guess, of course, but it beats the piecemeal method.