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July 19, 1992
"Federal Reserve's Economic Toolbox is Nearly Empty"
San Jose Mercury News

By Timothy Taylor
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SINCE PRESIDENT Bush took office early in 1989, the economy has fluctuated between torpid growth and outright recession. Even worse, the main macroeconomic policy now available for stimulating the economy -- the Federal Reserve's monetary policy -- is running out of ammunition.

The economy grew 3.9 percent in 1988, but from the middle of 1989 through the third quarter of 1990, the growth rate fell to 1.2 percent. Then the recession hit, and by the first quarter of 1991, the real economy was actually smaller than it had been in early 1989. Since then, with the bounce and resiliency of a wet towel, the growth rate has crawled back to perhaps 1.5 percent.

But each time the economy looks set to shine, new clouds gather. For example, growth appeared to perk up this spring. But then in June, the unemployment rate jumped from 7.5 percent to 7.8 percent, the highest rate since March 1984. Industrial production dropped 0.3 percent in June alone.

Since 1989, the Federal Reserve has tried to kick-start the economy into heartier progress by pumping money into the banking system, which tends to make credit available and drive down interest rates. The hope was that people and businesses would borrow and spend on big-ticket items like housing, appliances, new plants and business equipment, which would stimulate growth.

The part about driving down interest rates has worked well enough. In the aftermath of the latest cut on July 2, some banks are now paying less than 3 percent interest on savings accounts, rates that haven't been seen since the late 1950s. Interest rates for home mortgages have fallen back to where they were in the early 1970s, before the OPEC oil embargo staggered the global economy.

Of course, the lower interest rates have occasioned some griping, but that's expected. Any price change is a two-edged sword; swings in either direction are bound to injure someone. Lower interest rates make savers unhappy, but gladden the heart of borrowers. Personally, I'd love to be able to borrow at a low rate to buy a house and still receive high interest payments from the bank, but the world doesn't work that way.

But despite interest rate cuts, growth hasn't surged. Jack Beebe, Senior Vice President and Director of Research for the Federal Reserve Bank of San Francisco, explored some of the reasons why at a recent breakfast forum of the Pacific Research Institute. Beebe listed three factors that have been holding the economy back, all of which will persist for another couple of years.

  • As the federal budget deficit flirts with $400 billion, stimulating the economy with sizable tax cuts or spending increases becomes ever more unlikely. (box) Too much of the commercial real estate built in the 1980s continues to sit empty, which makes borrowing to build more office space somewhat unlikely.
  • Depository institutions, like banks and savings and loans, have been struggling with a new world of financial competition, where they no longer seem as necessary. After all, depositors can put their money in mutual funds, pay bills with a credit card, take out a car loan direct from a car company. Businesses often borrow by issuing bonds, rather than taking out a bank loan. In their current grim mood, banks and S&Ls are not eager to stimulate the economy by loaning lots of money.

Along with these factors, the Federal Reserve must worry that increasing the money supply too much will rekindle inflation. After bottoming out at 1.9 percent in 1986 (as measured by the Consumer Price Index), inflation sneaked up to 3.6 percent in 1987, 4.8 percent by 1989, and 5.4 percent in 1990. However, the rate for the last year has fallen back to just 3.1 percent.

Interest rates could conceivably tick down a bit more in the next few months, but from a broader standpoint, the Federal Reserve has gone about as far as it can go. It has already pushed short-term interest rates close to zero. Longer-term lenders won't cut interest rates until they believe that inflation won't bounce up again, reducing the real amount that they will receive from borrowers. However, convincing people that inflation will stay low may take years.

For what it's worth, most economic forecasters believe that growth will recover modestly in the second half of 1992, toward the 2 percent range, with inflation remaining low. But this growth will have to be earned the old-fashioned way, by growth in productivity, rather than spurred with cuts in taxes or interest rates.

Assessing blame for high budget deficits, or for why interest rates weren't cut sooner and faster, is good clean political fun. But if politicians truly care about the future, rather than the past, they must seek to establish an economic environment more conducive to productivity growth. That includes a few easy calls, like supporting research and development, and a great many policy brain-twisters, like improving education, encouraging savings and investment, training and retraining workers, and reforming America's health care and banking systems.

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