Brooklyn's Progress
April/May 2007

BY DR. IRWIN KELLNER, CHIEF ECONOMIST, NORTH FORK BANCORPORATION
AND MARKETWATCH.COM, AND WELLER PROFESSOR OF ECONOMICS, HOFSTRA UNIVERSITY

Reports that the Federal Reserve is ready to cut interest rates are greatly exaggerated.

Call it viewing the glass as half full, or maybe just plain wishful thinking. However you describe it, the markets' reaction to the statement that the Fed issued at the conclusion of last week's Open Market Committee meeting was hasty at best, misinformed at worst.

The statement may have changed a bit, but the Fed's intent remains the same –indeed, one might even say steadfast. Right or wrong, as far as the Fed is concerned, fighting inflation is still job number one.
 
Actually, unless the economy is in the tank, fighting inflation should always be the Fed's top priority. If the central bank doesn't safeguard the value of the money that it creates, who will?
 
Even now the Fed is not as tight as the 17 rate hikes since the middle of 2004 would seem to suggest. It may not be fully accommodating all the demand for money and credit, but it sure is accommodating a lot of it.

What makes me say this? Simple, just look at how fast the Fed is creating money. The three-month growth rate of the money supply M2 is now 8%. This is the fastest clip since early 2004 – when short-term rates stood at 45-year lows.

The 12-month change is also the most since 2004.
 
Indeed, this might explain why the rate of inflation, in the Fed's words, is "elevated," and why the central bank's "predominant policy concern remains the risk that inflation will fail to moderate as expected."

As the late great Milton Friedman said, "Inflation is first and foremost a monetary phenomenon." So if the Fed is going to bring the rate of inflation down to its "comfort zone" of 1-2%, it's going to have to do more than talk the talk – it will have to walk the walk as well.

Cutting interest rates is surely not walking the walk. If anything, it's running the other way, thereby exacerbating the economy's inflationary tendencies.

True, the Open Market Committee replaced the words "additional firming" with the words "policy adjustments." But since the Fed made more changes to the inflation portion of the statement, I can only surmise that it made these word changes to soften the blow a bit – not to imply that it is ready to cut rates at a moment's notice.

If the Fed believes its own rhetoric that "the economy seems likely to continue to expand at a moderate pace over coming quarters," implying that the woes of the subprime borrowers will not drag housing and thus the rest of the economy down into recession, then the central bank will hold rates steady.

Indeed, with inflation running above the Fed's comfort zone, growth slow enough to boost unemployment and unused capacity while deflating the stock market's rate expectations might just be what the central bank would like to see.
 
Me, I'd like to see less money growth – even if that means higher interest rates. 

Dr. Irwin Kellner serves as Chief Economist for North Fork Bancorporation and for MarketWatch.com, a leading interactive financial news Web site.  He also holds the Augustus B. Weller Distinguished Chair of Economics at Hofstra University, and is the author of Hofstra University’s Economic Report.  Dr. Kellner is widely quoted in the print media and continues to author articles dealing with economics, business and banking.  He frequently addresses the business community as well as community leaders, and appears regularly on Cablevision's News 12 Long Island, as well as on other programs in the U.S. and abroad.  For more information about North Fork Bancorporation, please visit the company’s Web site at http://www.northforkbank.com/.  This article was first published by MarketWatch on March 27, 2007.