NCPA - National Center for Policy Analysis

Should The Fed Target Interest Rates -- Or Gold?

July 2, 2001

The Federal Reserve has cut a key interest rate to 3.75 percent. It is said that the Fed is easing monetary policy, which should lead to faster economic growth; however, there has been little evidence of more business activity since the Fed first cut interest rates in January. Some economists question whether the Fed should target interest rates.

The Fed doesn't actually cut interest rates -- it increases the supply of money (liquidity), causing interest rates to fall. It only controls one specific rate, called the federal funds rate, which is the rate banks charge each other on overnight loans. When this interest rate falls, others should follow.

The Fed conducts monetary policy principally by buying and selling U.S. Treasury bills, notes and bonds. When it buys securities, it adds liquidity by creating the money to pay for its purchase. If it wishes to reduce liquidity, it sells securities from its portfolio.

Most of the money in our economy is actually created by banks. Thus the money supply is determined more by individual and business decisions than by Fed actions. This makes the money supply an unreliable indicator of Fed policy.

Now some critics say that interest rates are not a reliable indicator, either. They say the Fed has lowered interest rates without an accompanying increase in liquidity.

Former Vice Presidential candidate Jack Kemp says the Fed should target gold prices. If there is too much liquidity, inflation fears will cause gold to rise, while too little liquidity is deflationary, causing gold to fall (see figure). Kemp thinks the Fed should add liquidity until gold rises from its current level of $272 to about $300.

The Fed is unlikely to adopt the Kemp plan, but should ease monetary policy until some signs of inflation appear. Right now, there are none.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, July 2, 2001.


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