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Turn Off The Drip
The Fed should end the Chinese water-torture approach.


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Larry Kudlow

At today’s Federal Open Market Committee meeting the central bank should be aggressive, and not simply because the wartime economy is slumping badly. From the standpoint of a reformist monetary policy that relies on market-based price indicators, the financial and commodity evidence leaves the door open to a fed funds policy rate that could conceivably drop by a full point to 1.5%.

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Of course, the Fed is not going to do it this way because they are not operating on a true market-based price rule. Instead, Fed rate cutting moves could last into February.
This drip, drip, drip, Chinese water-torture approach — which really targets GDP growth rather than market prices — prolongs the downturn and delays economic recovery as consumers and investors wait to capture the lowest possible financing rate. Investors know there is a furniture sale out there, and they wait now and buy later in order to capture the discount.

Numerous market commentators express concern that the so-called real fed funds rate has dropped below zero, since the twelve-month change in the consumer price index is 2.6% and the current funds rate is 2.5%. (Subtract inflation from the funds rate to get the real funds rate.) In this view, policy is seen as overly stimulative — it could re-ignite inflation next year and trigger yet another speculative bubble, forcing the Fed to radically re-tighten policy.

But more-accurate inflation measures tell a different story, one that leaves considerable elbowroom for a much lower fed funds rate.

Alan Greenspan’s favorite inflation measure, the personal consumption expenditures deflator, has increased only 0.9% over the past year, leaving the real fed funds rate at 1.6%. Parenthetically, over the past three months the consumer spending deflator has registered a 2.4% rate of decline. On this basis, the so-called real fed funds rate is nearly 5%.

Probably the best market measure of inflation expectations is the spread, or difference, between 10-year Treasury notes and the inflation-protected 10-year Treasury. This so-called TIPS spread now stands at 1.3%, or 130 basis points. After numerous Fed rate cuts this year, this measure has actually fallen 100 basis points.

So, if in fact it is true that a zero real fed funds rate is appropriate in the context of economic conditions caught in the vice of deflationary recession, then the nominal fed funds rate could fall as low as 1.25%. Historically, the last 1% handle on the effective fed funds rate was registered in September 1961 (1.88%).

In this scenario, the central bank could conceivably reduce its policy rate by as much as 125 basis points. In other words, they have a lot more work to do. To maximize a shock-therapy jolt to the economy, the bank could take the funds rate down 100 basis points at today’s meeting.

Is a 1.5% fed funds rate a fanciful view at the extreme end of public discussion? Perhaps so, but it shouldn’t be. Another key market-based indicator, the well-known CRB commodities index, continues along a deflationary path. While commodities per se comprise 20% or less of the economy, they are a useful proxy for widespread price declines now occurring almost everywhere: energy, computers and technology, autos and other manufacturers, airlines, travel, entertainment and hotels, business services and even the price of Cipro, produced by the Bayer company.

These deflationary trends are muting the economic power of the money-supply increase recently produced by the Federal Reserve. True enough, as Milton Friedman and other monetarists have pointed out, money supply measures are expanding rapidly. What’s not true, however, is that this money increase will lead to higher inflation.

The reason? Money is changing hands, or turning over, at a very slow rate. In fact, the so-called velocity of money is declining faster than the rate at which the money supply is increasing. This is primarily because people are hoarding money as cash rather than investing or spending it in the economy. Liquidity preferences today are very high.

Uncertain times often lead to this risk-aversion, cash-hoarding effect, with the extra money put in circulation by the central bank finding its way into risk-free bank savings accounts and money-market funds instead of the productive economy. This of course does nothing to finance the next new technology idea or venture capital project that could streamline the economy and create another million new jobs.

The only money supply measure under direct Fed control is the monetary base, comprised of currency and bank reserves. Only the central bank, by purchasing Treasury bills from government bond dealers, creates base money by paying for Treasury bills with newly printed cash.

After shrinking the base by 3% last year, the Fed is expanding the base at an 8.5% annual rate this year. In normal times this might be enough to generate rising nominal income and stronger economic growth. But these are not normal times. Investment, production, prices and profits are falling. There’s also a war going on. As part of that war, there are still numerous threats to domestic security. While the vast majority of Americans support the war, and a recent Scott Rasmussen poll indicates that 60% believe that America has changed for the better, the fact remains that economic behavior in the midst of unfolding events has turned very cautious.

Heightened economic uncertainty from war and recession requires out-of-the-box thinking from policy makers. This is not an ordinary business downturn. The current slump can only be fought successfully if both tax and monetary policies provide for greater economic rewards to counter higher-than-normal economic risk.

Monetary policymakers should therefore be unafraid to inject unusually large amounts of new money to counter persistent deflation, and they should do so faster rather than slower. Fiscal policies should be reducing tax-rates on individuals and businesses by much more than is currently being discussed in Washington.

Greater after-tax incentives to reward investment and production will be necessary to hurdle over unusually high uncertainty risk premiums. A larger-than-usual rate of money creation is necessary to finance a re-energized incentive structure. Unusually low interest rates pull the package together. This is a time for pronounced risk-taking by policymakers in government and entrepreneurs in the private economy. Hopefully both groups will respond by thinking outside the box.



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