Is it better to slowly ratchet up the pressure or to hit hard all at once? This tactical question is one that central bankers share with generals—even though their objectives are quite different.
Recent U.S. military history favors the hit-‘em-hard approach. William Westmoreland was one of the Army’s most respected officers when he took command of U.S. forces in Vietnam in the early 1960s. But his implementation of Defense Secretary Robert MacNamara’s strategy of slow escalation is now widely criticized.
Norman Schwartzkopf, who served in Vietnam as a battalion commander, had broad autonomy of command when he led allied forces against Iraq in 1991. Operation Desert Storm was designed to deliver an immediate knockout blow. Schwarzkopf is a public hero; Westmoreland is tarnished.
When the Federal Open Market Committee meets on Tuesday, whom should Greenspan and his fellow committee members emulate: Westmoreland with his slow escalation of pressure, or Schwarzkopf with his lightning punch?
The last seven changes in the Fed’s discount rate have all quarter-point moves, three down and four up since January 31, 1996. This has lulled some with short memories into believing that 25 basis point movers are the FOMC’s modus operandi. In recent weeks, the media have speculated that Tuesday’s meeting will produce a half-point increase, generally characterizing that possibility as a more extreme move.
But in the longer history of Fed actions, 25 basis point moves are rather rare. The first 15 changes under Greenspan’s leadership were 0.5 percent or more. And while the FOMC made 25 discount rate changes in the nine years Paul Volcker was at the helm, none smacked of gradualism. Volcker shared more than a love of cigars with “Stormin’ Norman.”
Some 14 interest rate moves were 0.5 points and another 11 were Desert Storm-like moves of a full percentage point. Moreover, some of the increases under Volcker were accompanied by imposition of a 3 or 4 percentage point “surcharge” on banks that approached the Fed discount window too frequently.
Whatever happens this Tuesday, the debate about the efficacy of small, incremental moves vs. whopping markets upside the head with a 2-by-4 is one that is likely to continue among central bankers. It is not one to which economic theorists can contribute much, because it deals with practical nuances such as credibility and the mass psychology of markets. These are topics that don’t fit well into mathematical models.
Critics of incrementalism point to the experience of recent years. It was 1996 when Alan Greenspan first warned of inflationary pressures connected to booming stock markets. The Asian financial crises that followed actually led to looser money, and this easing was not reversed until the last half of 1999. Each time the FOMC boosts the discount rate or its target for the Federal Funds rate, markets take it in stride.
To critics of gradualism, that is a sign that U.S. monetary authorities may “get behind the markets.” That happens when financial markets see Fed actions as inadequate, and market fears of inflation begin to force up long-term interest rates independently of what the Fed does. When a central bank “gets behind the markets,” it has to scramble to catch up and it loses valuable credibility. Eventually it will be forced to take much sharper action to restore its reputation.
Defenders of FOMC policies in recent years retort that Volcker was justified in calling for full-point moves because he was dealing with a decade of full-blown inflation. Half measures were not called for.
But in recent years measured inflation has been nearly nonexistent. And a 25 basis point change from 4.5 percent to 4.75 percent is not much different that a 100 basis point change from 13 percent to 14 percent. The U.S. economy is much healthier now than it was in the early 1980s. There is no need for brutal course changes, just small, nuanced refinements.
That sort of argument infuriates critics, who see it as a return to the 1960s Keynsian mindset that the economy could be micro-managed with discretionary fiscal and monetary policies. It was just that sort of hubris that caused stagflation in the 1970s and 1980s, they argue. What was the use of all that economic pain if policy makers don’t learn from it? After all, Robert Lucas did win the Nobel Prize for demonstrating that Keynsian demand management was based on erroneous foundations.
I don’t know any more about what the FOMC will do on Tuesday than the next guy. But if its members really want to send a signal, they should think about 75 basis points rather than 50. I doubt that will happen, but if anyone spots General Schwartzkopf’s limo entering the parking level of the Fed’s Eccles building, Katie bar the door!
© 2000 Edward Lotterman
Chanarambie Consulting, Inc.