Despite overwhelming evidence that deflationary pressures are gathering force through the economy, Alan Greenspan & Co. have apparently decided to cut back on the amount of emergency liquidity they have been injecting in the financial system.
Incredible as this may seem — in view of the twin U.S. crises of war and recession — the overnight cash advances that were designed to prop up the banking system and the economy in the wake of the September 11 terror bombings are actually being throttled back.
The central bank has reduced its stimulus package to around $25 billion from an $81 billion peak money infusion on September 14, with less than $5 billion scheduled through the end of October. This amounts to a de facto tightening of monetary policy at a time when it is clear that the business-led recession of the past year is now spilling over into the consumer sector.
What a difference a week makes. On the morning the stock market reopened (Sept. 17), much praise was heaped on the Fed when it dropped the overnight federal funds rate to 3.0% from 3.5 %. Even better, in an innovative move, the central bank allowed its policy rate to be settled by the market, which promptly moved it down to the 2.0% zone. Now, however, the Fed’s decision to cut back on its lending stimulus has pulled the policy rate back up — actually above the 3.0% target. This, too, is a de facto tightening move, though it goes unnoticed by the general public. The timing couldn’t be worse.
While the Fed takes back its stimulus, the economy is suffering. There are massive airline layoffs, a virtual cessation of travel, and declining attendance at theaters, movie houses, and restaurants. There are business cancellations and disruptions to broker dealers, insurance companies, and other financial firms. There is a clear drop in shopping-mall traffic and a rise in credit-card delinquencies. On the New York City front, a deputy mayor tells me that the sheer volume of cleaning up ground zero could delay rebuilding efforts until the middle of next year.
All this foreshadows a deepening downturn over the months ahead. The National Association of Business Economists now projects the gross domestic product to fall 2.1% in the third quarter, 2.8% in the fourth, and another 1.9% in next year’s first quarter. In their view, we won’t see an economic recovery until the second half of next year.
Against this backdrop, what in the world can Alan Greenspan be thinking?
Certainly there are no inflationary pressures on the horizon. Commodity prices of energy, industrial materials, and farm crops are falling. Gold jumped temporarily, but is now easing back. The most recent consumer price report for August — a month before the terrorist attacks — registered a flat 0.0 reading for the prior 3-month period. Prices are going down, not up.
You would think that continued declines in employment, prices, and consumer activity would prompt more aggressive Fed easing, not de facto tightening. Yet, as the central bank slows its liquidity-creating lending operations, its policy target rate has been rising, not falling.
As a result, the bottom, or liquidity end, of the treasury market is again abnormally shaped — overnight money (3.0%) is yielding more than 91-day money (2.2%) and two-year money (2.9%). This is a message from the financial market that public cash demands are greater than the Fed’s cash additions. It’s a signal of recession not recovery. Does Mr. Greenspan listen to the market? Apparently not.
He certainly wasn’t listening last week when he counseled congressional leaders and White House officials to delay recovery stimulus plans for lower tax rates. While the Fed chairman argued that it was “far more important to be right than quick,” U.S. stock markets took their worst drubbing in 40 years, and equity values suffered a new $1.4 trillion loss. Think of it: Since early 2000, stock-market wealth has shrunk by more than $5 trillion. No wonder investor spirits are moribund and business confidence is dead in the water.
Instead of fighting markets the Fed chairman should join them. Let the market set the policy rate, and leave the $80 billion stimulus in the financial system until the markets tell the central bank it’s no longer necessary.
Expanding America’s productivity vigor with pro-growth economic policies must be a major goal if the war against terrorism is to succeed. Economic growth helped conquer Soviet communism in the Reagan 1980s, and it will defeat Bin Laden and his evil-doing fanatics now. While Special-Ops Forces are descending in Afghanistan, perhaps we need a wake-up commando raid on the U.S. Fed.