The Fed's Folly.

• Author: ZOAKOS, CRITON M.
• Position: Federal Reserve System - Brief Article - Statistical Data Included

Monetary policy mistakes, not market failure, are behind the U.S. slump.

After agonizing to find a way of putting it delicately, here it is: What ails the market is the Federal Reserve. There is no other cause. Fear to admit this fact causes confusion. Analytical gymnastics to find alternate explanations for the market's behavior also cause confusion. Admit that the Fed made a mess and clarity takes hold.

The Fed's blunder was the belief, back in 1999-2000, that the economy was suffering from "excess demand." No such excess demand ever existed. Yet the Fed started tightening in July 1999. When the tightening ended in December 2000, demand as measured in monthly retail sales was higher and supply lower than in June 1999. The Fed's tightening did not succeed in curbing demand. It succeeded in curbing supply. Four months after supply (capacity utilization) began dropping, demand did slow down. Not Fed tightening but the shrinking of supply caused the fall in demand. Which proves that we never had an "excess demand" problem in the first place.

It gets worse. Chairman Greenspan said early this year that we are going through an "inventory adjustment" because there is now "excess supply." Hello? How did we switch from excess demand to excess supply? The daily reading of corporate press releases this past winter does not suggest, "inventory adjustment." It suggests that people are locking up and heading for the golf course--driven away by the confused policy environment. Presumably, they would return Once the Fed got it right.

In trying to fathom exactly when the Fed switched from the "excess demand" to the "excess supply" rationalization, we took a second look at the published Federal Open Market Committee (FOMC) minutes. To our surprise, we noticed that the FOMC discussions contained a judgment that the economy began producing below "full potential" around July. Producing below "full potential," in our humble understanding, denotes weak supply. This FOMC judgment was repeated at the August, October, November, and December minutes. Yet each time, the Fed decided to keep the tight interest rates--causing a further weakening of supply, a further drop below "full potential."

Until December 19, 2000, the Fed was complacently watching supply drop. Then, with the new year, it flipped out about declining demand and began emergency rate cuts. With January retail sales at $206.5 billion, it claimed that the economy's problem was a lack of "confidence"...