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The Fed is once again missing the deflationary point.


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Larry Kudlow

Here’s a thought for the high priests of the monetary temple: ending deflation is more important than targeting the fed funds policy rate.

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Indeed, the best policy mix would be: 1) make the temporary liquidity injections permanent at least through year-end; 2) let the market settle the fed funds rate; and 3) lower reserve requirements.

Some twelve months after the economy fell out of bed during the presidential election last year, the Federal Reserve has still failed to come to grips with the fundamental cause of the economic slump — namely, a remarkable deflation of high-powered liquidity.

In effect, this is the first deflationary recession in four decades. The downturn cycles of 1969-’70, 1973-’75, 1980-’82, and 1990-’91 were all inflationary recessions. But with the partial exception of 1990-91, where government regulators induced a credit crunch following on the heels of a hike in the capital-gains tax rate, all the other recessions were caused by accelerating inflation (which drove tax-rates substantially higher).

This time, however, the deflation of the monetary base from 16% growth to a negative 2% decline between the end of 1999 and the end of 2000 was the single largest contribution to the deflation of stocks, commodities, interest rates, profits, cash flows, business investment, technology, and the overall economy. The terrorist bombings are intensifying the deflation, but the root cause was monetary.

I say this because once again everyone will focus on the federal funds rate as the principal instrument of Fed policy. But you know what? This downturn was never about interest rates. Nor was it about short rates, nor long rates. In prior inflationary recession cycles interest rates moved into double-digit territory or nearly so. But this time long-term Treasuries never even rose above 7%. And eight fed funds rate declines this year presumably engineered by the Fed merely followed the overall deflationary trends downward.

Speculation in Tuesday morning’s papers about a negative real fed funds rate continues to miss the deflationary point. To wit: Over the past three months the annualized CPI rate registered zero point zero, the PPI came in at a negative 3.6%, and the consumer spending deflator rose only 0.3%. So, if the overnight funds rate drops to 2.5%, that infers a real fed funds rate of the same magnitude. That’s quite high for a recession. And on a PPI basis, the real funds rate would be 6.1%.

Since the last FOMC meeting on August 21, the CRB futures index has dropped 5.2%. That’s a 37% annualized rate of decline, which would put the real fed funds rate at 39.5%! Not exactly easy money.

Monetarists argue that inflation is just around the corner, since the growth of the monetary base and M2 has increased mightily. They’re right about the upturn in money growth, but their analysis is strictly partial equilibrium. The fact is that the demand for cash balances continues to increase faster than the supply in this deflationary environment.

What’s more, it remains true that you can lead a horse to water but you can’t force it to drink. All the money supply in the world may not be sufficient to stimulate risk-taking and investment because risk premiums are incredibly high today.

This is not simply the credit risk associated with recessionary profit declines but, as my colleague Bill Kucewicz points out in a forthcoming piece, the war against terrorism at home and abroad has created a significant uncertainty premium on risk-taking. Only an across-the-board re-energizing of tax-rate incentives can offset the economic deterrents of excessive risk and uncertainty.

All this said, the best thing the Fed can do is unlock its policy target rate and continue to inject high-powered liquidity into the economy. At a bare minimum, the central bank should maintain its $40 billion to $50 billion overnight repurchase program until at least year-end. Let the money market set the funds rate.

How will the monetary agency know when its job is done? Watch financial and commodity market indicators. Real-time market prices have more information than monetarists or Phillips curve econometric models. When the overnight funds rate is comfortably below the 91-day T-bill rate, and when the bill rate is below the 2-year note rate, the Fed can take notice. When broad commodity indexes like the CRB or the JOC stop falling, or even rise a bit, the central bank will know its liquidity-supplying operation is complete.

Here’s a final thought. Precautionary cash-balance raising reached such a fever pitch last week following the terrorist bombings that demand deposit levels increased by an unprecedented $111 billion. Think of demand deposits as ready cash in checking accounts, including ATM-available accounts. Maybe everyone was turning their savings accounts into demand accounts in order to protect their ATM capabilities.

Whatever the reason, demand deposits are subject to the Fed’s 10% reserve requirement ratio; savings accounts are not. This means banks have to set aside a big chunk of vault cash to reserve against the increase in demand deposits. It also leaves fewer bank resources available for lending and investing activity. In effect, reserve requirements are a tax on bank credit and bank profits.

To make life easier for the banks, and to add even more liquidity to the financial system, the FOMC should lower reserve requirements today. In a deflationary environment, any cash flow improvement is helpful.



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