Monday, July 31, 2006

Has The Fed Gone Too Far?

It is difficult to judge the Fed without knowing what would have happened if a different policy course had been followed. But I think that the Fed always overreacts. Whatever the “right” policy is, they will do too much of it. This in turn requires them to be heavy with the antidote to their preceding mistake.

The huge liquidity move in 2001 through 2004 was excessive. And to the extent that it was excessive and lasted too long it was damaging. I think they should never have gone below 2%, and 2% should have been a six to 12 month affair with rates coming back up by the end of 2002. Instead they went lower (to 1%) in 2003 and stayed there until mid 2004. So the pot boiled over.

If only they would have the patience to wait for their medicine to take hold before upping the dose. They know that the lag time is about 18 months for peak effect on GDP and about nine months for the first real impact of their policy changes. And yet they get impatient and keep upping the dose.

The recent economic conditions are largely the result of last year's rate policy - when the target rate was still around 3%. Imagine how the economy will slow once the recent rate levels begin to kick in!

Now (at 5.25%) the Fed has already raised their target rate well above the natural equilibrium level. This is more than enough “medicine” to slow the economy, but it will take a while for the medicine to be digested. Any further increases will intensify the recession that will come soon (2007).


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