NCPA - National Center for Policy Analysis

When Will the Fed Start Tightening?

December 17, 2001

The Federal Reserve's interest rate cuts have brought the federal funds rate down to 1.75 percent, its lowest level since 1961.

Given that the time lag between episodes of monetary tightening and easing have been very short in recent years, it may not be long before the Fed raises rates to slow an accelerating economic recovery (see figure).

It may seem absurd to be discussing Fed tightening at a time when the economy is in recession, unemployment is rising and deflation, rather than inflation, appears to be the bigger problem.

But it is important to know that the Fed firmly believes, as an institution, that economic growth per se is inflationary. It says so in every monetary statement it makes.

As Cato Institute economist Alan Reynolds points out, the Fed says that economic weakness is what justifies its rate reductions, so obviously economic growth must be what justifies monetary tightening.

Economists call this the Phillips Curve trade-off -- higher growth stimulates inflation, slow growth causes inflation to fall.

Many economists, however, believe that growth doesn't have anything to do with inflation. How can producing more goods and services be inflationary, they ask, when inflation is fundamentally caused by too much money chasing too few goods? Increasing output per man-hour is, in fact, deflationary.

Nevertheless, the Fed has always believed that its job is to take away the punch bowl just when the party starts to get good, as former Fed Chairman William McChesney Martin once put it.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, December 17, 2001.


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