Tuesday, August 13, 2002

The Federal Open Market Committee (FOMC), which is the monetary-policy panel of the Federal Reserve, will decide today whether short-term interest rates should be reduced for the first time this year. Given recent U.S. economic developments, it’s an easy call. Short-term rates need to decline. In fact, Federal Reserve Chairman Alan Greenspan and his colleagues should chop a half-percentage point, or 50 basis points, from its principal target, the federal-funds rate, which is the interest rate banks charge each other for overnight funds.

The statement that the Fed issued after its last meeting (June 26) declared that recent economic information “confirms that economic activity is continuing to increase.” The Fed noted that “the growth of final demand” the crucial statistic that deducts changes in inventories from gross domestic product (GDP) “appear to have moderated.” But the FOMC reported that it “expects the rate of increase in final demand to pick up.” Concluding that “the risks are balanced with respect to the prospects” for attaining its two long-run goals of price stability and sustainable economic growth, which the Fed measures through final demand, the Fed left the federal-funds rate unchanged in June.

Since the June meeting, however, information regarding the condition of the economy has changed markedly. On July 31, the Commerce Department not only significantly revised downward its estimate of annual GDP growth for the first quarter from 6.1 percent to 5 percent; its estimate of growth for the second quarter came in at a remarkably weak 1.1 percent. Worse, the meager growth that was achieved in the second quarter was entirely attributed to increases in inventories. That’s not good. It means that the Fed’s crucial statistic, final demand, actually declined, plunging into negative territory after already having fallen precipitously from an impressive 4.2 percent annual growth rate in the fourth quarter to 2.4 percent in the first. Moreover, with the growth rate of consumer spending falling below 2 percent in the second quarter (which was less than a third of its growth rate in fourth) and with nonresidential fixed-investment spending continuing to decline, fears of a double-dip recession have understandably increased in recent weeks.

A double-dip recession in the United States would be a frightful development that must be avoided. It is frightful because it would almost certainly tip the world into a global recession embracing Europe and Japan. That hasn’t happened since 1974-75. Compared to an unacceptably low U.S. growth rate of 2.1 percent over the past four quarters, the eurozone area has grown a mere 0.3 percent, with Germany’s economy having declined 1.2 percent. Japan’s economy has declined 1.6 percent in the past year, and it is headed south again. With Latin America on the brink, now is not the time for a global downturn.

Following last year’s 11 cuts that cumulatively slashed 4.75 percentage points, the federal-funds rate has remained at 1.75 percent since December. It is often observed that 1.75 percent represents its lowest level in 40 years. Left unsaid is the fact that inflation has also reached a near-40-year low. The consumer price index, for example, has increased by only 1.1 percent in the 12 months through June. And, last week, the Labor Department reported that the producer price index for finished goods has declined by 1.1 percent over 12 months and that unit labor costs for the nonfarm business sector in the second quarter were 2.2 percent below their year-ago level.

If there is a pricing threat, it is from deflation, not inflation. The Fed has studied Japan’s disastrous economic experience following the bursting of its stock market and property bubbles more than a decade ago. Earlier this year, the Fed rightly concluded that Japan erred by not pre-emptively reacting on the monetary policy front in a sufficiently aggressive way. To prevent repeating Japan’s colossal mistake and to fight off an impending global recession, the Fed needs to act aggressively. Chopping off another 50 basis points from the federal-funds rate fulfills that need.

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