- The Washington Times - Friday, December 22, 2000

The Federal Reserve made another bonehead decision by failing to cut the key Fed funds policy rate and end the liquidity deflation that is damaging stock markets and the economy.

Shifting the so-called policy bias from fighting inflation to fighting recession may occupy the thoughts and minds of legions of Fed watchers. But this is mere rhetoric blue smoke and mirrors. The economy needs liquidity, not rhetoric.

As Fed mistakes mount, the need for President-elect George W. Bush to appoint independent thinkers to the three open seats on the Federal Reserve Board becomes more and more important. Institutional policy-making reform, where market price signals replace Phillips curves, should be an urgent priority.

Inflation fears and economic growth expectations are rapidly declining. That is the clear message of the Treasury market, where both real and nominal rates have plummeted and not just long rates, but even three-month bill yields, which have declined a half of a percentage point. If we had savvy thinkers at the Fed, they would have lowered the funds rate by the same amount. Meanwhile, gold remains low and King Dollar strong. There's no inflation in our future.

Stock markets plunged after the Fed's knucklehead decision. This continues a year-long pattern where bonds have been strong and stocks sick. I call it a recession trade. Recession trades are bad. Stable bonds and rising stocks are better. That's a growth trade. Does the Fed know the difference? Does it even care?

The Phillips-curvers on the Federal Open Market Committee must still be worried that there's someone out there left working and producing. That the level of the industrial production index has declined two straight months doesn't seem to matter much. Another four months of this and there will be an official recession.

In technical terms, as economic demands slow, or sink, the only way the Fed can maintain the prevailing 6* percent funds rate peg is to drain more and more liquidity from the financial system. In other words, the bank reserve supply has to be reduced as rapidly as the decline in bank reserve demand.

This is why the year-to-year rate of monetary base growth has been deflated to 1 percent from 16 percent over the past 11 months. The NASDAQ has also been deflated. Risk capital investing has been deflated. Lately, production, sales and consumer confidence has been deflated. Pegging the funds rate at 6* percent is a very bad policy.

Even a soft-lander like myself is starting to worry. Liquidity deflation is a tall monetary barrier to economic growth. And since Main Street folks now know from the Fed that short-term financing costs will eventually come down, they are going to defer spending and investment decisions until they can take advantage of lower rates. That is, if they still have any resources. But this deferral effect merely prolongs the economic slump. That is why the Fed should move now, not later.

Does the Fed understand this? Who knows. Policymakers who continue to obsess over the non-existent trade-off between growth and inflation probably have the blinders on when it comes to human action, or the discovery process embedded in the wisdom of market information.

Where to go from here? Economic redemption requires a Fed funds rate cut of 50 basis points. Waiting six weeks until the next Jan. 31 FOMC meeting is way too long. Right after the first of the year the Fed must begin to take action.

Markets are smarter than Phillips curves. But the Fed needs help from people who know this. Both tax and monetary barriers to growth must be reduced quickly. Otherwise, the soft-landing scenario will look like a triumph of hope over experience. Let's hope that help is on the way.

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

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