NCPA - National Center for Policy Analysis

Fed Slow To Turnaround On Interest Rates

January 8, 2001

On January 3, the Federal Reserve took an essential first step toward staving off a recession by cutting the federal funds interest rate from 6.5 percent to 6 percent. Unfortunately, its action may be too late.

The Federal Reserve conducts monetary policy as if there were no lag between when it acts and the effects of those actions on the economy.

  • Most economists would say that the ultimate impact of a Fed action to tighten or ease will come 9 to 12 months later.
  • Thus, the fall in unemployment and the rise in the stock market both drove the Fed to tighten monetary policy and raise interest rates beginning in June 1999.
  • Not surprisingly, the stock market peaked almost exactly 9 months later, as the lagged effect of the Fed's tightening took hold.
  • The Fed continued tightening through May 2000, suggesting that the depressing effect of the Fed's previous tightening will not have fully worked its way through the economy for another several months.

The Fed was moved to lower interest rates last week by an unexpectedly low statistic from the National Association of Purchasing Managers. Their index has been below 50 for 5 months in a row, indicating a contraction in the manufacturing sector. The 43.7 percent figure in December is the lowest since the recession year of 1991.

The Fed's policy of dribbling out rate cuts actually inhibits the beneficial effects of easing from taking effect, because investors have an incentive to wait until interest rates have bottomed before acting. Even if the Fed eases with uncharacteristic aggressiveness, the U.S. economy inevitably is in for several months of anemic growth.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, January 8, 2001.


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