- The Washington Times - Friday, February 16, 2001

Stock markets went nowhere during Alan Greenspan's three-hour testimony before the Senate Banking Committee. Mainly because the Fed chairman went nowhere and said nothing. Actually, stocks and bonds closed the day on the down side, sending a Bronx cheer to Sir Alan's performance.

As best I can determine from reading the script and watching the Q&A;, there was virtually no discussion of monetary policy. Believe it or not. Folks might think this a bit odd since the Federal Reserve is the government agency in charge of monetary policy, and this was, after all, a semiannual monetary policy report to the Congress.

But, in fact, very little was said about important matters such as the federal funds rate, the high-powered monetary base (both of which are directly under the Fed's control), or the value of our nation's currency, a k a the dollar, which is mightily influenced by Fed actions on the funds rate and high-powered cash.

Why the senators failed to grill Mr. Greenspan the same way, for example, they might touch up Treasury Secretary Paul O'Neill on taxes, or Defense Secretary Donald Rumsfeld on the Strategic Defense Initiative, or Attorney General John Ashcroft on social policies, is beyond me. But for some reason, Mr. Greenspan escapes the normal oversight scrutiny reserved for other federal policy-makers.

Then again the Fed steadfastly refuses to acknowledge that overly tight money is the primary cause of the growth recession the economy is presently experiencing. This bureaucratic silence is called cover your keister.

The chairman discussed the economic drag effects of higher energy prices and overinvestment in technology (largely driven by Y2K though this, too, was not acknowledged), but he failed to even hint at the obvious point that the Fed raised its policy rate way too far a year ago and deflated the monetary base way too much.

These money mistakes raised barriers to economic growth and risk-taking. The mistakes increased the financing cost of money and reduced investment demands. In effect, overly tight Fed policy last year created a significant tax-increase effect on the usefulness of money and economic growth.

During the Senate hearing, the politicians repeatedly talked about tax policy, especially asking how big a tax cut is too big. But nobody asked how big a money supply increase is too big or how big an interest rate increase is too big. And, of course, none of the senators asked specifically about the future course of fed policy. I mean specifically. Like, for example,what fed funds rate might be consistent with domestic price stability.

Price stability and currency stability are really the twin goals of monetary policy. Yet Republican and Democratic members once again glossed over these issues, thereby giving the Fed a free ride to manage the nation's money in a highly discretionary and virtually eccentric manner, without clear rules or guideposts.

At bottom is the continuing confusion over Fed operating procedures. So long as the central bank targets GDP and various economic and unemployment statistics, they are doomed to undershoot or overshoot their policies, either generating excess cash or a cash shortage. If, on the other hand, members of Congress would press the Fed for a market-based monetary policy, then a steadier Fed would make fewer mistakes and thus contribute to steadier economic growth.

My own view right now, judging from market interest rate and gold price movements, suggests that a 4 fed funds rate would be just about the right policy target. I would prefer a 50 basis-point rate reduction before the March 20 meeting, and then another 25 basis-point rate cut at the meeting itself.

How do I get to 4 percent? There are a couple of market-based routes. One is the gold price. Roughly a year ago, it peaked at $315 when the fed funds rate was 5 percent. Today gold is around $260, roughly 17 percent below its year-ago level. Take 17 percent off of the 5 percent funds rate that prevailed when gold last peaked, and you get a new 4 percent fed funds rate target.

Here's another funds rate benchmark approach. The shortest dated inflation-adjusted Treasury note (TIPS) that matures July 15, 2002, currently yields 2.74 percent. Assuming an expected inflation rate of 2 percent or less (derived from various TIPS spreads) gets me to a 4 percent nominal fed funds rate target (2.74 percent real rate plus a 2 percent expected inflation rate, which is actually a bit lower depending on which TIP spread one uses).

Question is, will the Fed get to 4 percent on the fed funds rate target? Hard to say, but people are likely to defer spending and investing actions until they are sure of capturing the lowest possible financing rate for mortgages, consumer purchases or longer-term investments. That's the message of the markets.

The Fed, however, may not get to 4 percent anytime soon. But the longer they wait, the longer the economy will pause. As I tried to read between the lines of the Greenspan operetta, it looks like the central bank is expecting 2 percent or so economic growth this year with about a 2 percent inflation rate. Despite the fact that 2 percent is well below the economy's potential to grow, the Fed may be satisfied with it.

In terms of investment strategy, a less restrictive Fed is better for the stock market and the economy than an overly restrictive one. So I continue to believe that the S&P; 500 is a buy rather than a sell. But a below-potential economy still works against the most growth-sensitive sectors, including technology, which should be underweighted. Defensive value stocks should be overweighted in this sluggish growth environment.

The Fed message of economic underperformance is the reason for the stock market's muted reaction to Mr. Greenspan's testimony. It was decidedly below potential.

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

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