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The Fed’s in a Fog
We need vision, not rate-obsession.


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Larry Kudlow

Fed Chairman Alan Greenspan presented another of his cover-your-keister testimonies before the Joint Economic Committee this week, and the Dow Jones index dropped 150 points in response. The maestro tried to make the case that the economy was stabilizing in the period immediately before the terrorist bombings. But data on production, employment, and business-capital spending clearly show the opposite. The economy was sinking into recession before the shock of the war on terrorism.

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Greenspan was unusually opaque, even by his own standards, offering virtually no clues about the Fed’s monetary strategy for the next several months. In the event of another war shock or unexpectedly significant economic decline, we have no idea what additional liquidity flows the Fed might provide, if any. Instead, we have Greenspan’s tired and misguided warning that stimulative tax cuts might adversely affect long-term interest rates. This rate-obsession is not only historically unfounded, it’s an evasive, murky position. Webster’s defines murky as “characterized by a heavy dimness or obscurity caused by, or like that caused by, overhanging fog or smoke.” That pretty much defines our Fed chairman these days.

This is an economy in the throes of deflationary recession, with broad-based commodity indexes slumping badly. According to the Commodity Research Bureau composite, which has fallen nearly 20% this year, every price category is registering deflationary recession: industrials are down 38%, energy is off 36%, livestock and meats have lost 12%, and grains have given up 9%.

To be sure, Greenspan’s Fed has made some appropriate moves of late: it has injected a net increase of $35 billion in new liquidity, while reducing its federal funds policy rate a full percentage point to 2.5%. Yet worrying over long-term rates in such an economic environment makes little sense. The good news about this commodity deflation is that it surely foreshadows a near-zero future inflation rate that will keep interest rates down. Even the poorly constructed consumer price index should produce breathtakingly low inflation over the next 12 to 18 months (at least). And certainly, the positive shock of declining energy prices will stimulate economic growth and reduce inflation in the period ahead. Rates will remain historically low, Mr. Greenspan.

The dollar offers more evidence that the Fed chairman’s rate-obsession is misguided. Relative to domestic commodity prices, the purchasing-power value of the U.S. dollar has appreciated 20% this year. Relative to major foreign exchange rates, the dollar exchange index has appreciated 5% year-to-date. When a currency’s domestic and international value goes up, its underlying inflation rate goes down. Lower interest rates follow obediently.

With all this evidence at hand, Alan Greenspan’s fixation on the impact of tax cuts on bond rates is difficult to fathom. In meeting after meeting on Capitol Hill he has warned lawmakers that tax cuts resulting in budget deficits will raise bond yields and depress growth. Carrying this illogical logic even further, Treasury Secretary Paul O’Neill has even warned that deficits will raise the inflation rate.

A recent memo from the Senate Budget Committee contradicted these views. The memo stated that large budget deficits as a share of gross domestic product in the 1980s and early 1990s coincided with a long-term decline in interest rates. Ten-year Treasury rates dropped nearly 11 percentage points between 1980 and 1993, while 91-day Treasury bill rates descended 13 percentage points in that period. Since 1994, interest rates have bounced up and down as the federal government shifted from deficits to surpluses.

If Mr. Greenspan were analytically honest about the fiscal past, he would note the importance of supply-side policies that significantly reduced marginal tax rates and thoroughly deregulated the U.S. economy. As a result of these economic growth policies, a massive flood of new investment capital, work effort, and production absorbed the existing money supply and slew the anti-growth evils of double-digit inflation and interest rates.

Right now, the ailing U.S. economy — caught between the twin risks of war and recession — needs a supply-side jolt. If it pays more after-tax to invest, take risks, produce, and work, then these economic factors will be supplied in greater abundance. If in the short-run the budget moves into deficit, it is of no consequence. A $100 billion tax cut that reduces marginal rates on capital, businesses, and individuals will in two or three years generate a sufficient overflow of national income to replenish budget surpluses in due course.

Any near-term deficits would be the lowest of the past five cyclical recessions. Isn’t this an acceptable trade-off for true economic growth? Rather than murkiness, we need vision. Vision wins wars.



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