Alan Greenspan went to Capitol Hill this week to sell the idea that a “noticeably better” economy is just around the corner. Problem is, the Federal Reserve chairman has been saying this for three years. Will this be the year he’s on the money? No one can be sure.
Right now, weekly unemployment claims are rising, indexes that measure business health are falling, and retail sales are nearly flat. The economy has scarcely grown over the past six months, with real gross domestic product registering a paltry 1½ percent pace. This is a growth recession — and with worker productivity rising more than twice as fast as business output, the risk of higher unemployment is substantial.
The increase in private sector GDP, adjusted for prices and excluding trade, has steadily slowed from better than 5½ percent a year ago to less than 1 percent in the first quarter. Meanwhile, non-defense spending by the federal government has averaged 11 percent at an annual rate over the past two quarters. Were it not for that spending, overall GDP might well have been scored as a two-quarter decline, indicating a return to outright recession. But it is precisely that domestic overspending, uncontrolled by a Republican Congress and president, that is holding down economic growth by absorbing scarce resources from the private sector.
Commodity price indexes, including gold, are excellent real-time measures of the economy and inflation. But after rallying this year — suggesting a positive reflation scenario — commodities have turned over.
So, once again, all eyes are on the fed funds policy rate. At the very least, a 50 basis point drop in the Fed’s key interest rate — from 1.25 percent to 0.75 percent — would serve as a liquidity insurance policy against the risk of additional price deflation or other unforeseen shocks that might in fact send the economy into a second official recession.
The ongoing problem, however, is that you’re never sure Alan Greenspan has his eye on the right ball. If the Fed decontrolled its target rate — in effect, letting it rise and fall with the market — and instead sent new money into the economy until long-term Treasury rates, gold, and commodity indexes start moving higher again, they would then have the money-creation story right.
Might the Fed actually consider such a market-price-rule reform? Perhaps. Buried deep in Greenspan’s testimony, the chairman asserted that the Fed receives “continuous information from commodity and financial markets.” Well, it’s about time.
At this stage of the game, following a three-year downturn in stocks and the economy, new investment incentives from lower tax rates to encourage new capital formation are undoubtedly more important than lower interest rates from the Fed. The biggest problem facing the economy is not geo-political risk but a massive capital shortage. Unless share prices and wealth are rebuilt, we will suffer from sub-par economic growth for as far as the eye can see. Budget deficits at all levels of government will continue, while real wages and salaries will erode.
To be sure, all is not gloomy on the economic front. Today’s somewhat healthier stock market along with certain bond-yield indicators suggest that the quality of business credit has improved and that profits are on the upswing. Falling energy prices are also a good sign, spelling relief for businesses and households in the period ahead.
Still, the risks of continued weak growth in the spring and summer quarters, with additional deflation (or disinflation, as the Fed chairman put it), remain. The reflation scenario, illustrated by prior gains in gold and commodity prices, is still plausible. But it is by no means assured.
Sub-par economic recovery is still a major threat. Congress must do its part and deliver economy-stimulating tax cuts. No “itty bitty” tax cut, as the president likes to say, will do. And the Fed, meanwhile, must stay loose with the money. The two go hand in hand: If a supply-side tax-cut package makes it out of Congress, a new Fed easing will be necessary to finance the surging investment that will follow.
More money-adding from the central bank and pro-growth tax reform from Congress could trigger a huge bull-market rally — one that signals we’ve turned the prosperity corner. If policy makers act boldly, this three-year economic sickness can finally be cured.
— Mr. Kudlow is CEO of Kudlow & Co.