- The Washington Times - Friday, January 5, 2001

The Greenspan Fed has finally woken up and smelled the coffee. After shilly-shallying around in recent months with a no one's-in-charge image projected to an increasingly alarmed investing and working public, the Fed at last took a clear action by reducing its key policy rate by half a percentage point, dropping the fed funds rate to 6 percent from 6.5 percent.

Up to now the Fed has been fighting the wrong demons. Forward-looking market price indicators such as sinking bond rates and weak gold, along with a failing stock market, have been screaming that the real problem is deflationary recession caused by a shortage of liquidity (and rising tax burdens).

Instead of recognizing the market message, Fed policy-makers stubbornly held on to their Phillips Curves and their NAIRU models and kept withdrawing liquidity in order to fight so-called inflationary growth and successful wage-earners.

So while bond rates and stock prices kept falling, the Fed stayed overtight and kept deflating the monetary base. This measure of high-powered liquidity has collapsed to a 0.5 percent rate of decline over the past 12 months from its early 2000 peak growth of 18 percent.

Liquidity deflation has not only sunk the stock market, a leading indicator of the current economic slump, it has also set up a spate of credit problems, which are weakening the economy. Statistic after statistic shows the soft landing scenario to be in greater jeopardy.

The Fed's job of expanding high-powered money is far from over. A weak first-half 2001 economy is already baked in the cake from last year's monetary overkill. Declining real interest rates (10-year TIPS) and nominal corporate bond rates suggest much greater declines in the fed funds rate are necessary.

Right now the fed funds futures market infers another 25 basis point decline at the Jan. 31 Federal Open Market Committee meeting. The euro dollar futures market is hinting at an additional 50 basis point drop in the fed funds rate by June. Hopefully the Fed will oblige.

But there are two key points for investors and policy-makers. First, the Fed should follow bond and commodity markets; they are the best forward-looking policy guides to domestic price stability.

Second, Fed funds rate declines do not by themselves ensure an adequate volume of liquidity necessary to fund economic activity. Monetary base growth requires the stepped-up purchase of Treasury securities by the Fed. If gold prices and bond rates start shooting up, then the Fed has over-liquefied. Should gold prices and bond rates continue to fall, the Fed remains too tight.

Just as a guess, monetary base growth should probably accelerate to 5 percent or 6 percent. But the central bank will know the proper volume of high-powered money in relation to economic demands for that money by watching inflation-sensitive market prices. In other words, drive the Fed by looking through the front-view windshield, instead of driving with the rear-view mirror.

Phillips Curve-style targeting of economic statistics is a perfect example of rear-view mirror driving. Not only does it assign non-monetary causes to inflation, which is itself truly a monetary phenomenon, the NAIRU/People's Republic of Cambridge, New Haven and Princeton policy-style uses yesterday's stale news to promote an elitist and ill-founded view that somehow too many people working and prospering is a bad thing.

That the Fed has turned tail and moved in a different direction does not solve the current economic malaise. The central bank can create money, but it cannot produce goods or capital investment.

Only individuals responding to proper after-tax rewards for work and investment can spark true economic growth recovery. In the past year rising tax bracket creep has transferred about $80 billion from private hands to government coffers. Roughly another $80 billion has been drained from oil consumers to OPEC producers as a result of the energy shock.

Lower tax-rates will replenish this lost private sector purchasing power and reinvigorate economic growth incentives. The Bush tax plan is right on target, though it would be improved by adding tax-rate reductions for businesses and capital gains, along with marginal rate relief for individuals.

Over the past year Clinton policies of high interest rates, rising tax burdens and additional regulatory costs have stifled growth. It is to be hoped that Treasury Secretary-designate Paul O'Neill will shift the policy mix toward lower tax rates, regulatory relief and sufficient Fed liquidity so people can put new tax incentives to work. As well, hopefully the new administration will appoint independent-thinking new Fed members who understand that markets are better policy tools than discredited econometric models.

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

Sign up for Daily Newsletters

Manage Newsletters

Copyright © 2020 The Washington Times, LLC. Click here for reprint permission.

Please read our comment policy before commenting.


Click to Read More and View Comments

Click to Hide