- The Washington Times - Monday, December 18, 2000

Both commodity and financial market price signals, as well as newly-released economic statistics, point to an increasing likelihood the Federal Reserve will lower its fed funds policy rate by one-quarter of a percentage point when the committee meets tomorrow.

This despite the Wall Street mantra from conventional thinkers who still believe it is OK for the Fed to wait another six weeks until their New Year meeting on Jan. 31. But six weeks is too long for an economy whose rate of decline appears to be accelerating and where inflation-sensitive price indicators are suggesting that already excessively tight liquidity is still deflating.

Wednesday's retail sales report surprised consensus forecasters with an outright decline of four-tenths of 1 percent following a downward revision to sales in the prior two months. Real consumer spending in the fourth quarter now looks to be a paltry 2 percent, with holiday sales the slowest in five years. Not only did car sales decline, but so did general merchandise store sales. Chain store sales on a year-to-year basis continue to come in several percentage points below a year ago.

On top of this, inventories remain higher than expected including both auto and non-auto stocks. As a consequence, overall fourth-quarter real gross domestic product may be barely above water. Meanwhile, core producer prices were flat following last month's one-tenth of 1 percent drop. Price declines were registered in prescription drugs and computers (minus 14 percent over the past 12 months).

Both intermediate and crude wholesale prices dropped in November and core crude prices have deflated 10 percent at an annual rate over the past three months. Overall consumer goods prices increased only one-tenth, while capital goods were flat for the second straight month. In the open market, crude oil prices have dropped $10 since mid-September from $37 to $27, a 27 percent decline.

Fed officials and Wall Street economists who still fear inflation should have their heads examined. Either that or they have significant attention deficit disorders. More Ritalan, perhaps; but lower price pressures are unfolding across-the-board.

Take a look at the fixed income markets. Ten-year Treasuries have eased to 5.5 percent from 5.8 percent about a month ago. Baa corporate bond rates have dropped to 8 percent from 8.5 percent not long ago. And perhaps the most revealing indicator of a likely near-term Fed-easing move, three-month Treasury bill yields have opened up a substantial discount to the 6.5 percent fed funds rate.

About a month ago T-bills were running around 6.4 percent. Today they are just above 6 percent and still falling. Fed policy should follow declining market rates with a lower funds rate.

Meanwhile, in liquidity terms, the year-to-year change in the monetary base has slowed to less than 1 percent, a breathtaking decline from the 16 percent growth rate registered at the turn of last year. Regrettably the steep downward-sloping growth rate of the monetary base is running parallel with nosediving retail sales.

As a leading indicator of aggregate demand, or nominal GDP growth, plummeting monetary base growth is not at all reassuring that even a near zero inflation rate can forestall recession unless monetary policymakers quickly take action. Thinking about this, a 50-basis point fed funds rate decline would be even more appropriate than 25-basis points, though conventional lunkheads on the street can't even see their way to calling for a 25-basis point Fed move next week.

In technical terms, what is really happening here is that while the Fed maintains a 6.5 percent funds rate target, aggregate demand pressures in the economy are rapidly falling. In order to maintain the prevailing funds rate peg, the Fed has to keep withdrawing bank reserves and draining liquidity. All this does is make already overly tight reserve conditions even tighter. Witness the retreat of spot gold back below $270 per ounce and the recent upturn in the dollar exchange rate despite clear signs of a U.S. economic growth slump.

One final thought: The Fed can't do all the recession prevention work alone. It can produce more money and temporarily stimulate aggregate demand, but much-needed monetary injections cannot increase the supply of investment, production and employment. That is the job of tax policy.

In a free economy it must pay to work, produce and invest, after-tax. In current circumstances it is incumbent on fiscal policy to reinvigorate economic incentives by reducing marginal tax-rates. In recent years tax bracket creep has pushed millions of successful earners into higher tax brackets. This is why personal tax payments as a share of personal income have reached the post-World War II high. Our overly progressive income tax system has been penalizing work achievement.

Fortunately, President-elect George W. Bush mentioned tax cuts in his re-acceptance acceptance speech last Wednesday night. The Bush team is now crafting a broad-based tax-cut plan that will be acceptable to Republicans and centrist Democrats. Hopefully the final product will be made retroactive to Jan. 1, 2001.

In order to maximize economic growth recovery, a retroactive tax cut will avoid the deferral effect where people would postpone spending and investing decisions until lower tax rates are in place. The same is true for Fed interest rate policies. The longer the monetary priests wait to lower rates, the more prolonged will be the economic slump. Everybody knows Fed rate cuts are on the way, but folks will wait to spend and invest until the rate cuts actually occur. Therefore, the sooner the job gets done, the faster will be the recovery. But the longer the Fed waits, the worse will be the economic outcome.

This is one key reason why stock markets haven't yet rallied, despite the pro-business Bush victory. Markets know he is going to need help from the Fed. Let's hope Greenspan & Co. are willing to make peace with the president-elect right away. With a nicely wrapped Christmas gift of much-needed monetary stimulus. Help is on the way.

Lawrence Kudlow is chief U.S. investment strategist and chief U.S. economist at ING Barings LLC.

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