An Interest Rate Target With No Bulls-Eye
Copley News Service, 07/03/2001
It’s disconcerting to hear calls for Japan to lower interest rates when its rate on overnight money already is virtually zero (actually 0.35 percent). Japan suffers from deflation that has depressed its economy and is helping drag down the world economy. Pushing interest rates below zero, however, is not the answer to Japan’s problem. Do we expect Japanese banks to pay people to borrow money?
How on earth could the Bank of Japan have gotten interest rates to zero while prolonging and deepening Japan’s deflation? The answer is interest-rate targeting, a misguided approach to monetary policy that has failed in Japan and is now failing here.
Political writer Bob Woodward nicknamed Fed Chairman Alan Greenspan “The Maestro,” but there are some sour notes wafting out of the central bank’s Marble Palace these days. The Fed has continuously lowered its interest rate target for six straight months, by 275 basis points, only to see price-sensitive commodities and the price of gold continue to decline, signaling an ongoing deflation. Rather than giving Japan advice, it would be better to send Greenspan a message that it’s time to stop targeting interest rates here at home and begin using the price of gold as a reference point for the dollar.
My critics will say I’m no economist. Of course I’m not an economist. Neither was Adam Smith, who was a professor of moral philosophy at Glasgow University. I’ve always said if all the economists in the world were laid end to end, it would be a marvelous thing for humanity since they usually arrive at the wrong conclusion sitting in their ivory towers. I have arrived at a conclusion based on years of observing, studying and participating in economic policymaking and participating in actual commercial endeavors.
As I wrote in the Wall Street Journal last week, I believe the economy here and around the world is being seriously harmed by the Fed’s inability to manage a floating paper dollar. With the dollar serving as the numeraire for the whole world, a deflating dollar means trouble for the global economy. Commerce slows, people lose their jobs and businesses fail when declining prices make it difficult for firms to earn a profit.
There is clear evidence that by targeting interest rates the Fed is depriving the economy of the full measure of new money (liquidity) that it needs. The price of gold has fallen from $385 in 1996 when the Fed first stumbled into deflationary monetary policy, and at $270 it is actually lower today than it was six months ago when the interest rate reductions began. Commodity prices are near their 15-year lows, and commodity futures prices reveal no market expectation that they will rise soon. The interest rate on one-year loans (3.63 percent), which the free market sets, is lower than the interest rate on overnight money (3.75 percent), which the Fed sets administratively, a classic sign the Fed’s monetary policy is too tight.
Here’s the rub: The Fed has no way to know how much liquidity the economy needs nor can it know what interest rates should be. The Fed simply guesses how much new money markets demand and then guesses again what interest rate is compatible with that amount of new money creation. That’s where the Fed’s interest rate target comes from – out of thin air as the result of two heroic guesses.
No wonder the Fed’s Open Market Committee is constantly erring. There is no conceivable way 12 human beings can know from one day to the next precisely how much liquidity the economy needs and exactly what interest rates should be. Only the market can process all the information required to discover those answers and reveal them in market prices.
Fortunately, there is a better approach than interest-rate targeting. The Fed should stop guessing at the amount of liquidity the economy needs and let markets make that determination, and the Fed should stop targeting interest rates and let markets set them. The best market signal the Fed can watch to determine how much liquidity to inject or withdraw from the economy is the price of gold. If the Fed were to announce a policy of stabilizing the price of gold within a narrow range, preferably closer to $325 an ounce than to it’s current price of $270, it would end the deflation, and the engines of growth would start up again.
If the Fed persists in its ill-fated struggle to stop the deflation by gradually lowering interest rates, we could be in for a long and painful wait for prices to grind down to a new equilibrium. The good news is that at some point prices will stabilize and growth will resume. The bad news is that many people will suffer a lot of unnecessary pain as businesses fail and workers lose their jobs in the process. Included among deflation’s casualties could be the very elected officials who have handed their fate over to misguided central-bank bureaucrats by remaining silent as Maestro Greenspan conducts the economy as a slow waltz in three-quarter time.
Jack Kemp is a co-director of Empower America, a Distinguished Fellow of The Competitive Enterprise Institute and a nationally syndicated columnist. His column is distributed by Copley News Service.