The Picture-Perfect Fed

So now the Fed has taken all the rate cuts back. Last summer and fall, when it sometimes felt as if the global economy were on the verge of a massive nervous breakdown, the Federal Reserve cut interest rates three consecutive times–including one between-meetings rate cut–to ensure that suddenly panicky lenders didn’t strangle access to credit. The U.S. economy, perhaps as a result, didn’t even hiccup, while the stock market, which had plummeted in the wake of Asian turmoil, Russian devaluation, and the collapse of Long-Term Capital Management, came roaring back. But after today’s 25-basis-point rate hike, the federal funds rate now stands at 5.50 percent, exactly where it was before the chaos of last summer.

To me, this looks like nearly picture-perfect central banking, especially since the U.S. economy continues to grow at a fast pace, unemployment continues to shrink, and inflation at the consumer level remains in check. There are voices of dissent who think that Alan Greenspan is paying too much attention to Wall Street and that the continued rise in stock prices is entirely the product of the Fed’s distribution of easy money. But that case has been weakened not only by the Fed’s own rate hikes but also by the powerful rally in the bond market in recent weeks. Thirty-year interest rates are back down near 6 percent, after trading close to 6.5 percent, and they would not be there if bond traders–for whom vigilance about inflation is a cardinal law–thought the Fed was letting us all live high on the hog by printing lots of greenbacks.

In any case, Fed-watching has become so ubiquitous that it’s harder to say something new about Alan Greenspan than about Martha Stewart. But there are two important things to keep in mind about this most recent hike. The first is that even if the Fed’s performance over the past year and a half looks perfect, we don’t actually know if it was. By this I mean something more than just the obvious point, which is that history has no control group. I also mean that the most important driver of non-inflationary growth–business productivity–remains something of a mystery to economists.

Productivity growth remains very strong, at 4.1 percent in the most recent quarter, though the rate of that growth has slowed slightly (very slightly). And it seems increasingly clear that the effects on productivity of computerization and the Internet are real and not temporary blips. But why those effects are being felt now, how long they will last, how much of productivity growth is being driven by businesses running leaner than they once did: These questions don’t have firm answers. Nor, for that matter, do we really understand why productivity growth slowed so rapidly in the 1970s. So while the Fed deserves credit for its performance, most of what’s going on in this Goldilocks economy is out of its control.

The second thing worth noticing is that the popular understanding of the role of the Fed seems to have shifted in the past year and a half, arguably as a result of its quick action last year. The conventional wisdom was that it took six months to a year for a Fed rate hike to work its way into the economy, which makes sense since raising or lowering interest rates generally isn’t like slamming a door open or shut. It’s more like easing it open or closed. But what we’ve seen more recently is the idea that one of the Fed’s key roles is psychological. It wasn’t the literal opening of the taps last fall that mattered but rather the symbolic message the Fed sent lenders, which was that it was OK to take on a little risk at a time when the only thing anyone wanted to do was buy 30-year U.S. bonds. Similarly, no one really believes that raising the Fed funds rate from 5.25 percent to 5.50 percent is going to put the brakes on economic growth (although the gradual rise from 4.75 percent to 5.50 percent has to have had some effect). But people do believe that it will send the right message to lenders and borrowers. To be sure, ultimately the message carries weight because it’s backed by the Fed’s actions. But in concrete terms, the Fed’s actions probably won’t have an effect for six months to a year. The Fed’s message, though, is already at work right now.