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Lotterman: Slowing of money growth not as dire as media portrayed

Sometimes economic news is not as important as the media make it out to be. That was the case last week when the Federal Reserve's Open Market Committee decided to pause its constriction of the money supply. The target rate will stay unchanged at 5.25 percent.

This was news in the sense that a trend has changed. A short pause, however, has little long-run importance for our country.

Some stories emphasized the magnitude of the series of target interest-rate increases that the Fed interrupted Tuesday. One news story described it as "the longest period in which the Fed has continuously raised rates." Another described "the largest cumulative interest rate increase in the history of the Fed."

The first assertion is correct, the second not. Both are highly misleading, nonetheless. While the Fed hiked its target Fed Funds rate by 4.25 percentage points in just more than two years, consider that the starting point was 1 percent, which was historically low and anomalous.

When the Fed lowered its target to 1 percent in 2003, the rate had not been that low since 1958. When the Fed started using Fed Funds as a policy indicator in 1982, the target rate never fell below 3 percent before Sept. 11, 2001. It clearly would not have been lowered that much if not for the great political and economic uncertainty resulting from the attack on the World Trade Center. Thus, it would be equally correct and more relevant to describe recent increases as "a very gradual return to near-normal rate levels."

The two-year gradual slowing of money growth was nothing compared to a six-month period between July 1980 and January 1981, when the Fed Funds rate jumped from 9 percent to 19 percent.

Yes, short-term rates are higher now than in 2003. But 5.25 percent is lower than the rate that prevailed in all but a few months of the boom period from 1994 to early 2001.

Adjusted for inflation, as measured by the "core" Personal Consumption Expenditure index announced last week, the current rate is about 2.9 percent. Using the overall Consumer Price Index, the real rate is less than 1 percent. It was below that level only 25 months out of the 20 years preceding the Fed's loosening in 2001. Despite the Open Market Committee's long series of quarter-point baby steps, short-term rates are far from tight by historical standards.

Moreover, despite popular belief that all interest rates move in lockstep with increases in Fed targets, important rates for households such as fixed-rate mortgages and car loans have increased much less than 4.25 percentage points.

The $64,000 question is what the Fed does next. The FOMC, which meets eight times a year, has meetings on Oct. 24-25, Dec. 12 and Jan. 30-31. More economic indicators will be measured in the interim and the effects of high oil prices and international uncertainty might become clearer in a few months.

The Fed might choose to stay at the 5.25 percent level or to constrict money growth, which would force rates still higher. Monetary easing is not going to be in the cards for some time.

The U.S. no longer occupies some sort of economic island, isolated from the rest of the global economy, even though economists still teach introductory courses as if that were true. The U.S. money supply, which is controlled by the Fed, has great influence on overall liquidity and interest rates within our country. But it no longer is the only important factor.

Capital now flows much more freely from country to country than it did even 25 years ago. The actions that other countries take to increase or decrease their money supplies spill over to our country just as Fed actions affect theirs.

Monetary tightening is the rule in recent months with the Bank of Japan, the European Central Bank and the Bank of England all increasing their target interest rates. And such tightening is likely to continue for a time.

Furthermore, we have a new Treasury secretary charged with persuading the Chinese to reduce the value of the U.S. dollar relative to its renminbi.

The Chinese would have to slow their own monetary growth and stop buying as many dollars. Fewer dollar purchases by China and other Asian nations means less capital flowing into the United States and higher interest rates even if the Fed does nothing more.

On the other hand, oil-exporting nations like Saudi Arabia and the smaller Gulf states are awash in dollars and euros as a result of high oil prices. Some estimates are that OPEC nations will get more than $200 billion in additional income per year compared with what they got before September 2001.

They can spend this money or save it. In the 1970s, when these nations enjoyed a similar inrush of dollars, they spent about 75 percent and saved the rest. Now the proportions are reportedly reversed — they are spending about a fourth of their additional income and investing the rest.

This means petrodollars are flowing back to New York, London and Tokyo to buy stocks and bonds. All other things being equal, this increases funds available for borrowing. But greater saving by OPEC countries also means less consumption, and that means less demand for goods and services produced by the U.S. and other industrialized nations.

Economist Edward Lotterman teaches and writes in St. Paul, Minnesota. Write him at ed@edlotterman.com.

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