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Every Which Way But Loose
The Fed should cut the interest rate, and get some cash into the pipeline.


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Larry Kudlow

Not one in a thousand economic talking heads understands that the true role of the Federal Reserve is to control the basic money supply. Call it what you want: the monetary base, Federal Reserve credit, Reserve Bank credit, or the consolidated balance sheet of the Federal Reserve system. Or just call it plain ol’ high-powered cash. That’s the Fed’s business.

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Sure, Alan Greenspan has convinced a lot of people that the Fed’s job is to tinker with interest rates. But that’s a false perception. The market sets the rates — not the central bank. The only rate the Federal Reserve controls is the discount rate, which is the rate at which it temporarily loans reserves to member banks.

The basic policy rate — a.k.a. the federal funds rate that TV and radio economists track as closely as their portfolios — is in fact heavily influenced by the Fed. But to a large extent this rate, too, is set by the supply and demand forces for overnight bank reserves (or, again, plain ol’ money). This is known as the federal funds market. The interaction of reserves supplied by the Fed and the reserves demanded by the banking system actually set the price of overnight money, which we all call the fed funds rate.

The Fed adds or subtracts reserves — or money — in order to stabilize the fed funds target rate, which has been held at 1.75% since last November. Right now, as the recovery has hit a soft patch, declining bank demands for reserve monies are probably inducing the Fed to remove cash from the economy in order to keep the fed funds rate steady at 1.75%; exactly what they shouldn’t be doing. This interest-rate target only slows the monetary lever and removes stimulus from the economy. And it’s absolutely the wrong time for the Fed to be removing stimulus.

In a free economy like ours, the public determines where the money goes — checking accounts, money-market funds, savings accounts, investments, or the stock market. But recently all these demand-side measures of money have slowed in tandem with the Fed’s less accommodative supply of high-powered cash.

There are several variables at play here. The public is showing a high demand for cash balances, itself a symptom of investor-risk aversion. There’s a corporate credit crunch that has caused a shrinkage of balance sheets and market capitalizations. And we are tending toward deflation.

Over the past three months, wholesale prices of consumer goods have fallen by 2.3%, autos by 3%, capital goods by 1.1%, and computers by 20%, all at annual rates. Overall, the producer price index has fallen 2%.

If these falling price trends continue, it will be difficult for profit margins to hold up. These margins had been improving for nearly a year, but they are beginning to narrow once again, an ominous sign for the stock market. It’s also a negative for corporate cash flow. Businesses faced with high real interest expenses need to cover burdensome debt, and they need cash to do so.

Obviously, it’s time for the Fed to loosen up and get more money into the pipeline. And how should the Fed do this? The next time the Federal Reserve meets, on August 13, it should drop the target for the federal funds interest rate, allowing the Fed’s open market desk to buy more Treasury bills and inject more cash into the financial system. Remember, it’s the cash injection that’s important — not the level of the fed funds rate.

Some commentators scoff at the proposal to lower the fed funds rate by a quarter or half of a percent. But they miss the point. The key is liquidity, which is in short supply. In a softening economy, the only way the Fed can pump up liquidity is by dropping its target rate.

And investors should not judge the Fed through interest rates alone. Instead they should watch gold, commodities, and the interest rate differences among Treasury securities. If these indicators are rising, then the Fed is doing its job to stabilize domestic prices and foster economic growth. Yet today, all of these indicators (which Alan Greenspan would be wise to follow, too) confirm the slowdown in high-powered money.

The Fed meets next on August 13. Let’s hope they loosen up their policy. The real way.



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