A Funny Thing Happened on the Way to Rate Cuts

The Federal Reserve under Alan Greenspan changed the way that people thought about the central bank. Previously, the Fed was almost parental in its role—making sure that the kids did not get too happy when the economy was growing and conversely, tried to make the bad times a bit more palatable. Then Greenspan came along and acted as if any pain in the system was intolerable. He would prevent our suffering and as a result, he became touted as every investor’s savior.

He didn’t start out that way—in the period from 1990-1991 the Fed policy under Greenspan was able to help the economy emerge from recession, without damaging its inflation-fighting credibility. But Greenspan changed over the course of his tenure. He morphed into the easy-going parent—the one who allowed the kids to party at his house without any ramifications and even cleaned up after the party.

The New Greenspan came into his own in 1998, when a large hedge fund, Long-Term Capital Management, was on the verge of collapse. As the firm imploded, the Fed lowered interest rates, which allowed investors to borrow money more cheaply to invest in the securities market, thereby averting a potential downswing in the markets. This action became known as the “Greenspan Put,” as investors assumed the Fed would act to save the system through monetary policy that would elevate market stability above all else.

Unfortunately, actions like these are what sowed the seeds of our current problems. In the aftermath of the tech-bubble bursting, the economy faced significant hurdles. Adding to the already-tense situation, the 9-11 attacks forced action by the Fed to help avoid a complete melt-down. In retrospect, 2001-2002 is not where the problems occurred. It was in 2003, when the Fed maintained the federal funds rate below the rate of inflation even after the pickup in aggregate demand occurred after the 2003 tax cut and the economy was recovering.

Greenspan was fortunate in that his policy decision happened to coincide with a time when globalization’s deflationary effects were peaking. The current Fed under Ben Bernanke has not been so fortunate. But a funny thing happened on the way to this round of rate cuts---there are significant ramifications that are not allowing them to work as well as they had worked under Greenspan. Sure the Fed has slashed rates, but as we sit at 2%, this Fed is dealing with the nagging problem of inflation. Gone are the fruits of globalization!

It is important to note that 2% federal funds rates is actually a stimulative level, but it is creating inflation and increasing the likelihood of elevated inflationary expectations. Bernanke and Co. can not afford to be the cool parents that allow the party to continue. These times demand some adult intervention. Without it, there will be a significant price to pay for all of us.