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Fed Back From The Dead
Rate cut is a much-needed dose of shock therapy.


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Larry Kudlow

The Fed provided a much-needed dose of shock therapy Wednesday, igniting the stock market and opening the door a little bit wider to an economic rebound that could appear by the fourth quarter. In a surprise move, Greenspan & Co. lowered its policy rates by 50 basis points to 4.5% on overnight federal funds, and 4% on the discount rate.

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Markets roared across the board. So much for those goofball analysts who keep telling us that lower interest rates don’t matter. Of course they do.

Think of it as lifting an onerous tax on money. There wasn’t ever any real inflation, as attested by the weak gold price and strong dollar exchange rate. When the Central Bank kept jacking rates up last year, they imposed a significant tax on investment demand and capital efficiency. Investor spirits slumped while capital costs soared. Along with spiking electricity prices, and a cumbersome tax-drag effect from excess budget surpluses, this nasty economic brew generated a recession in investment, profits, and production.

But the Fed’s unexpected move Wednesday infers a degree of monetary urgency, which heretofore had been missing. It’s a strong, and very positive, recovery signal.

Supposing the Bush administration can pull together a front-ended tax-stimulus package this spring, one that includes a downpayment on lower income-tax rates and a capital-gains tax cut, then fiscal shock therapy could jolt the stock market and the economy even closer to recovery.

Back to the Fed. Almost two years ago, on the air, I nominated Greenspan for a Nobel Prize. He had stopped global deflation, and was accommodating the technology-driven growth cycle here at home. But by early 2000, the four-term septuagenarian had relapsed back to stock-market bashing and Phillips Curve thinking that equated strong economic growth with rising inflation. As the Fed grew tighter and tighter, and the stock market sank lower and lower in 2000, I withdrew Greenspan’s Nobel Prize. For his sake, I hope he did not spend (or invest) the million-dollar paycheck.

Of course, readers know that I believe in redemption and salvation. So if Sir Alan keeps moving the policy rate down where it belongs, below the 4%, 3-month Treasury Bill rate, say to around 3.5% by June, the shape of the entire Treasury securities yield curve will be positively sloped and, hence, “normalized.” This would indicate adequate high-powered liquidity to finance economic recovery. It would probably induce economic activists to stop delaying investment decisions, because they would assume the Fed has gone far enough.

And an upward-sloping yield curve also provides impetus for a much-needed expansion of bank credit creation.

Loan demand in the slumping economy is nil. Commercial paper finance has been plunging as businesses slash inventories. But, if the Fed funds rate drops below all other Treasury rates, then banks can borrow at the funds rate (say 3.5%) in order to purchase two-year government securities at the prevailing 4.25% market yield. This purchase of government securities by banks injects new credit into the economy. Meanwhile, banks can finance the two-year note purchase at a positive carry over the Fed funds rate.

I don’t mean to get too technical, but this is an important way to stimulate the economy through bank credit creation. That is why the Central Bank must continue to march toward a 3.5% Fed funds rate at the next meetings in mid-May and late June.

Will Greenspan do it? Wednesday’s surprise action suggests that he will. We learned that there’s still a pulsebeat at the Fed. The vital signs are reappearing. Heck, a new Nobel Prize could hang in the balance — not to speak of the economy and future wealth creation.



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