The Fed of Yesteryear Is Dead

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e betting is that the Federal Reserve won't raise interest rates at this week's meeting of the Federal Open Market Committee, its key policymaking body. There are already complaints that the Fed, which cut short-term rates to near zero in late 2008, is waiting too long to reverse low rates. Last December, the Fed increased rates by a quarter of a percentage point. It hasn't done anything since.

"The Fed will make a major mistake if it doesn't raise rates," says economist Mark Zandi of Moody's Analytics. "The job market is strong and very close to full employment. Inflation is close to target (2% annually) and financial markets are in good shape."

Yet, Zandi doubts the Fed will raise rates by another quarter percentage point.

The case for standing pat was made by Lael Brainard, a Fed governor, in a recent speech. "Since 2012, inflation has tended to change relatively little ... (while) the unemployment rate has fallen from 8.2% to 4.9%," she said. Without accelerating inflationary pressures, policy should still favor job creation, she argued.

It's a close call. Whatever happens, the mere existence of debate attests to a remarkable change. It wasn't that long ago that the Fed was seen as almost all-powerful. It gave us (so it seemed) the "Great Moderation" -- a quarter-century (1982-2007) of economic growth with only two mild recessions. A few flicks of its short-term interest rate, up or down, could contain inflation or sustain growth.

No more. Now the Fed and other major central banks seem deeply frustrated. They've flooded the world with cheap money. By Moody's estimates, the amount is $13 trillion. That was used to buy bonds and other securities. It includes purchases by the Federal Reserve, the European Central Bank, the Bank of Japan and the Bank of England. For all their trouble, the central banks have got no more than a weak recovery that avoided a second Great Depression.

You can argue that this is itself a major achievement. It may be, but it falls well short of the prevailing view of the Fed and other central banks as economic powerhouses that could engineer strong recoveries. Central banks aren't as influential as we supposed. Low interest rates -- a product of both policy and wider economic forces -- haven't had the expected rejuvenating effect.


One explanation lies in the high and unsustainable debts that fueled the Great Recession. "Debt recoveries are not the same as ordinary business cycle recoveries," Harvard economist Carmen Reinhart recently told a conference at the Peterson Institute. Consumers and companies cut debt loads and rebuild savings. Lenders are more restrained in their lending; borrowers are more restrained in their borrowing. All this curbs spending.

A variant -- one often made by this reporter -- is that the recession's severity, almost entirely unanticipated by economists, business leaders and government officials, has made households and enterprises more precautionary and protective. They save more and spend less to shield themselves against future slumps and unpredicted calamities.

"People thought they were richer," economist Jason Cummins of Brevan Howard, a hedge fund, said at the Peterson conference. "Businesses have stopped growing investment. You give businesses a lower cost of capital (lower interest rates), but they're not investing."

Central banks are searching for new ways to revive their economic power. One idea tried in Europe and Japan is "negative interest rates."

Former Fed chairman Ben Bernanke describes it this way: "Instead of receiving interest on the reserves they hold with the central bank, (commercial) banks are charged a fee on reserves."

The hope is that, to avoid the fee (in effect, a tax), banks will lend out the money. The modest use of negative interest rates in Europe and Japan so far has been inconclusive or disappointing. In the United States, Fed Chair Janet Yellen has suggested that negative rates would be used only as a last resort.

The old Fed is dead. The notion that it could orchestrate economic growth within narrow bounds was excessively optimistic and unrealistic. It may be, as economist Allan Meltzer of Carnegie Mellon University has long argued, that basic problems burdening the economy can't be solved by increasingly large doses of easy money and credit. If too many rules and requirements thwart business startups, easy money is not a solution.

But the public may think it is. The Fed is now a prisoner of exaggerated expectations created in a friendlier era. If it fails to live up to those expectations, it may become the target of the public's wrath. There are already signs of this. It will do no one any good to be angry at the Fed for things it can't do.


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