- The Washington Times - Monday, July 2, 2001

The recent decision of the Federal Reserve to drop its key policy rate by only one-quarter of a percentage point was a tepid and disappointing move, one that was greeted skeptically by financial markets.

Creating more confusion than clarity, the central bank's accompanying statement described the economy as weighed down by "declining profitability and business capital spending, weak expansion of consumption and slowing growth abroad." Sort of like saying things always look darkest before they turn completely black.

Yet, inexplicably, the Fed took its weakest action in six months. Almost certainly, monetary policy will be back later this summer with a few more rate cuts. The Fed's pessimistic assessment of the economy leaves the door to future easings wide open.

But the likelihood of additional interest-rate cuts in the future creates a perverse incentive for activists in the economy to postpone or delay the very spending and investment decisions that could bring the slumping economy out of its stupor.

Think of it this way. Suppose there's a car sale scheduled a month from now, when prices will be discounted 20 percent. Potential car buyers will not go out and shop immediately, but instead they will delay their purchase until the 20 percent sale actually occurs.

So it is with interest rates. People will delay decisions to buy furniture, home appliances, computers or stock market investments until it is clear that Fed easings have come to an end and interest rates have bottomed. Right now, for example, there is more than $2 trillion of cash laying fallow in money-market funds. But folks are not likely to put that money to work until they believe interest-rate cuts are over and financing costs are at rock bottom.

But it is exactly this delaying effect, caused in large measure by the Federal Reserve's indecisive strategy, that could prolong the economic slump. Timing is everything, and you can bet that when it comes to future interest-rate declines or tax cuts, a well-informed public will always patiently wait for the best deal.

Hence, a wiser course for the Fed would be a big-bang move to drop its policy rate by at least another one-half of a percent and then declare a moratorium on future rate cuts for at least six months. This would accomplish two important goals.

First, a clear signal of bottoming rates would encourage consumers, investors and businesses to get off the sidelines and start putting cash to work.

Second, a bigger interest rate cut would result in a much larger addition to the basic money supply controlled by the central bank. This is necessary to spur falling bank loans and prop up sagging commodity prices. Right now, prices are falling everywhere, and deflation is becoming a problem.

And this is happening not just in the techie area, where prices of computers, cell phones, palm pilots and semiconductor chips have been dropping for some time, but industrial prices for aluminum, copper and zinc, farm prices on wheat and corn, precious metals like gold and silver, and energy costs from electricity, gasoline and natural gas. They are all falling like stones.

While the tax cut effect of falling commodity prices is a welcome relief for household pocketbooks and business profits, commodity deflation should be neutralized with significant liquidity injections of new money by the Fed before the deflationary threat gets out of hand and sinks the entire economy.

In general, financial and commodity prices are better guides to monetary policy than the outdated economic models used by the Fed. Right now, these market indicators are signaling that policy is too tight.

In order to promote non-inflationary recovery, Fed Chairman Alan Greenspan and Co. should return to an approach it used effectively during key periods of economic stress in the 1990s. Then, the central bank made sure that its policy target rate the so-called overnight federal funds rate was kept roughly three-quarters of a percent, or 75 basis points, below the rate at which the U.S. Treasury sells its two-year debt in the bond market.

With two-year Treasury bonds now yielding around 4 percent, this would mean a 3 percent fed funds rate. So the Fed should come back in July with a half-point rate cut that would finally end the easing cycle.

Decisive action like this would remove monetary uncertainty and ignite a brisk recovery. Certainly Greenspan & Co. owe it to an American public that hungers for a quick return to prosperity.

Lawrence Kudlow is CEO of Kudlow & Co., LLC, and CNBC's economics commentator.

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