Whither the Fed?

Doug Henwood of the Left Business Observer comments on US economy: "Really weak employment report this morning -- just 32,000 new jobs, way way below both recent trend and expectations -- and earlier months were revised down. U.S. economy really seems to be slowing down . . ." ("Employment," LBO-talk, August 6, 2004).

Is the Fed still committed to a series of quarter-point hikes -- including one in September -- over the next 18 months? Then, Alan Greenspan may accomplish what the anti-war movement and the Green Party failed to do: deliver the coup de grace to George W. Bush and make the next POTUS John Kerry a weak president without a big mandate at the same time.

Gary Pollack of Deutsche Bank in New York "expects the Federal Reserve to raise interest rates next week and then skip at least one month" (Courtney Schlisserman, "U.S. Payrolls Rise 32,000 in July, Smallest This Year [Update4]," Bloomberg.com, August 6, 2004).

Then again, according to the Financial Times, Knut "Wicksell is the outside economist who has had the greatest influence on the Fed's current thinking":

Knut Wicksell made his name in Sweden in the late 19th century as a polemicist, lecturing on prostitution, alcoholism and overpopul-ation. He was jailed late in life for a speech that questioned the virtue of the Virgin Mary.

His main contribution to economics was his theory that there is a natural rate of interest consistent with stable commodity prices and balanced supply and demand for capital. This contribution has been ignored by subsequent generations of academic economists. Gregory Mankiw, now chairman of the White House council of economic advisers, discusses the Wizard of Oz in his textbook -- but not Wicksell.

However, judging by the statements of Federal Reserve policymakers this year, and the decision to raise the federal funds rates last month, Wicksell is the outside economist who has had the greatest influence on the Fed's current thinking.

Fed officials have acknowledged the influence of the natural interest rate theory, although in the Fed's modern parlance the focus is on a neutral interest rate consistent with long-run sustainable economic growth and price stability.

When the Fed raised rates this month, its statement stressed: "Even after this action, the stance of monetary policy remains accommodative". The committee reiterated its belief that "policy accommodation can be removed at a pace that is likely to be measured". Such statements are built on logic that there is a Wicksellian rate of interest the Fed will work its way back to.

Wall Street economists are used to the notion of interest rate neutrality as a rule of thumb. The Taylor rule, a standard model for analysing Fed policymaking developed by John Taylor, undersecretary of the Treasury for international affairs, has at its core the assumption of a real interest rate -- stripping out inflation -- that is constant at 2 per cent.

But some academic economists have been surprised at the Fed's embrace of a theoretical notion considered rather antiquated. In 1930 John Maynard Keynes, the founder of modern macroeconomics, dismissed Wicksell's theory as chiefly of historical interest.

On a strict interpretation, the framework yields the implausible prediction that if the Fed keeps the federal funds rate below the natural rate forever the economy will grow above its potential rate forever, and that this will generate inflation that accelerates forever.

"There is no logical or empirical basis for such a line of reasoning," says James Galbraith, an economist at the University of Texas at Austin.

Mr Galbraith suggests that the natural rate theory is a convenient pretext for the Fed -- which has a dual goal of price stability and full employment -- for raising rates when the economy is well below full employment. . . . (Andrew Balls, "Fed Rates Theory Echoes 19th Century Swede's," Financial Times, July 12, 2004, p. 6)

Cf. Peter Coy, Rich Miller, Lauren Young, and Christopher Palmeri, "Is A Housing Bubble About To Burst?" (BusinessWeek, July 19, 2004); and Mark Weisbrot, "The Unbearable Costs of Empire " (BusinessWeek, July 29, 2004).

Let's watch the Fed and the housing market as we gear up to greet the Republicans in New York City and begin planning for an inauguration protest against the Democratic White House to Bring the Troops Home.