President-elect George W. Bush finally got around to meeting with Federal Reserve Chairman Alan Greenspan yesterday in Washington. As the debate now focuses on the economy and Mr. Bush’s tax cut plan, it was the right signal to send at the right time. Now that Americans know who their next president will be, much of the country’s attention will be focused on the Federal Reserve’s policy-setting meeting today. In order to ensure the soft landing of the U.S. economy, which the Fed is striving to engineer, the monetary authority should opt to cut interest rates.
Vice President-elect Dick Cheney has warned that a recession could hit America “somewhere down the road.” Indeed, not only are concrete consumption and production economic indicators slackening, but the so-called “psychology indicators,” also a crucial factor for growth, are turning bearish. Retail and auto sales and factory orders are dropping. Consumer confidence is off. Personal income fell for the first time in two years and companies’ third quarter, after-tax profits rose only 0.6 percent, the weakest performance in nearly two years. Initial unemployment claims reached a two year high in late November.
Given this economic backdrop, fears that Mr. Bush’s recommended tax cuts could over-stimulate the economy are clearly unfounded. Although the hard-working American taxpayer deserves a tax cut regardless of the performance of the U.S. economy at any given moment, it just so happens that Mr. Bush’s proposed cut could give the economy a helpful prod at a critical time. Mr. Bush said he discussed the possibility that a reduction in marginal tax rates could “serve as an insurance policy against a potential economic downturn” during his private meeting with Mr. Greenspan.
Investors most fear an inversion of the new economy’s “virtuous cycle” of growth. Venture capitalists willing to take high risks have fed the innovation that has spurred the non-inflationary growth of the past decade. The strides in technology have allowed companies to expand and cut costs at the same time. But if capital continues to dry up as the economy slows, than a dreaded vicious cycle could ensue. As investors become more risk-averse, innovation stalls, the economy contracts more severely and firms have limited technological resources to keep costs down.
In hindsight, the economy would be better off under looser monetary conditions as high growth levels off. Mr. Greenspan himself has aptly described the delicate balance of this stage of the economic cycle. “In periods of transition from unsustainable to more modest rates of growth, an economy is obviously at increased risk of untoward events that would be readily absorbed in a period of boom. The sharp rise in energy prices, if sustained, is worrisome in this regard,” he said on Dec. 5 in a speech before a group of bankers in New York.
It is at these transitional stages that a policy-maker’s decisions are most deeply felt. With this “increased risk” in mind, Mr. Greenspan should lower rates, since the effects of this move won’t be felt for months to come.
When Mr. Greenspan hinted he envisioned a rate cut in the not-too-distant future, markets rallied. Once the Fed actually cuts rates, venture capital and equity purchases could regain some momentum. Unfortunately, many Fed watchers expect Mr. Greenspan & Co. to reiterate a likely easing in the offing, but to leave rates unchanged today. If the Fed waits too long, however, and risk aversion prevails, the economy could be in for a rough landing.