Last winter and spring, it seemed to many that the Fed's interest rate increases, designed to ensure that inflation remained under control, were having no effect. The economy was rolling merrily along, apparently oblivious to the series of rate increases that began in June of last year. The new economy, so the argument went, was unstoppable. Higher interest rates couldn't slow it down. Monetary policy wasn't working the way it had in the past.
My short answer to this argument was "Nonsense." And, indeed, the unstoppable new economy argument disappeared several weeks ago, as evidence of the effects of higher interest rates became manifest. What can we learn from this episode? What changed so quickly?
First of all, Fed decisions to raise the intended, or target, federal funds rate by 25 basis points in June, in August, and again in November of last year brought the level of that rate back to where it had been in the summer of 1998, before the Russian bond default and the Asian financial crisis. The 1999 rate increases, then, reflected the passing of the Asian crisis and not a stance of increased monetary policy restraint in any fundamental, longer-run sense.
This year, the Fed increased the intended funds rate by 25 basis points in February and March and by another 50 basis points in May. These increases brought the intended rate to a level 100 basis points above the level prevailing in 1997 and 1998, before the Asian crisis.
We should draw two lessons from this experience. First, the interest rate increases last year just kept up with the economic recovery following the Asian crisis. Did the rate increases have no effect? If a driver has his foot on the brake going down a steep hill but the car maintains a steady speed, are the brakes not working?
Second, monetary restraint acts with a lag. The fact that the economy continued to demonstrate extraordinary strength last winter and spring was perfectly consistent with past experience. As monetary restraint took hold this summer, the economy became slightly less buoyant and more balanced. Employment growth slowed a bit and housing starts actually fell somewhat. Indeed, one economic indicator after another fell into line showing that the economy was continuing to grow, but at a little bit slower rate than earlier this year. All the while, inflation remained relatively low and stable, reflecting success in the Fed's efforts to achieve this fundamental policy goal.
Monetary policy does affect the new economy after all.