Why Must We Go to Extremes?
The overnight interest rate will likely be cut next week.


David Malpass

Expect the Federal Reserve to cut interest rates on June 25 — more likely by 50 basis points than 25. But understand that while a cut of the federal funds interest rate to 1 percent or 0.75 percent is a significant event in U.S. monetary policy, the action will not have much near-term effect on the economic outlook.

Due to the non-deflationary value of the dollar, a constructive, multi-year reflation will occur regardless of another cut in the overnight interest rate. Real interest rates are already negative, so a rate cut won’t have much impact — except to the extent that the Fed will change deflation expectations. In this regard, the Fed’s policy statements are more important than the interest rate itself.

The reaction of the stock market to the rate cut may be the most telling indicator, given its current importance in repairing business confidence. On the one hand, equities usually like low interest rates, but on the other hand, equities don’t like extremes — or uncertainty about the impact of future rate hikes. On Thursday the stock market had a weak performance, and part of that was due to concern about the Fed choosing to resort — or having to resort — to an interest-rate extreme.

The economy should churn out relatively strong growth (4 percent or more) in the second half of 2003 and in 2004. Commodity prices will rise as will bond yields. Another interest rate cut, depending on the Fed’s logic for it, may accelerate the economy some.

After that, short-term interest rates should rise in 2004 as the Fed responds to economic growth and to the rapidly increasing market distortions related to prolonged negative real interest rates.

The market expects a cut, and it’s hard to imagine that the Fed has an interest in disappointing expectations. It seems a safe conclusion that the Fed will drop its interest rate by a full half point. The Fed will explain the rate cut as an “insurance” measure, implying that it is a low-cost action with substantial benefits in the unlikely event of another deflation.

The result, however, is extreme: an overnight interest rate of 0.75 percent at a time when the economy is growing, the dollar has fallen to a non-deflationary level, unemployment is at 6.1 percent, and a massive growth-oriented tax cut has been enacted.

And the cost of interest rate extremes — from 6.5 percent in January 2001 to a possible 0.75 percent in June 2003 — is substantial in terms of distortions within the economy.

Rather than invoke the need for deflation insurance, the Fed could have explained deflation pressures in terms of the strong-dollar policy of the 1990s, and also made a clear distinction between its recent policy (non-deflationary value for the dollar, negative real interest rates) and Japan’s.

In a September 25, 2002, Wall Street Journal article, I argued that

Three major debates over monetary policy are in full swing — how to combat deflation, the central bank’s role in controlling asset-price extremes, and the proper response to fiscal deficits. How these questions are resolved will have a dramatic effect on global growth in coming decades. At the moment the debates are headed in the wrong direction. They don’t offer an explanation for the deflation of the 1990s, let alone a policy bridge to price stability, economic growth and tax reform in the 2000s.

Monetary policy is very powerful. Mistakes can start both inflation (as in the 1970s) and deflation (as in the late 1990s). The central bank can stop these by matching the supply of dollars with the demand for dollars, a step Japan never took with the yen. The 2001 interest-rate cuts weren’t as powerful as some had expected because real interest rates were still very high and the dollar’s strength was still causing deflation.

In November 2002, the Fed lowered rates another 50 basis points and, more importantly, made it clear that it understood the risks of deflation and had the tools and resolve to stop it. The dollar weakened to a non-deflationary level and real interest rates fell into negative territory. That, it appears, ended the risk of deflation.

What about the weaker dollar in 2003? That’s evidence of ample dollar liquidity. Under its policy of targeting the federal funds interest rate, the Fed provides unlimited amounts of liquidity at 1.25 percent. This is enough to meet the increased demand for dollars following the tax cut and the diminished uncertainty about Iraq.

The combination of an accommodative monetary policy and a big, investment-oriented tax cut are providing massive stimulus to the economy, which is responding.

Foreign central banks, meanwhile, are amplifying the accommodative U.S. monetary policy. Low U.S. Treasury-bond yields reflect, in part, foreign central bank bond purchases. In many cases, they are printing local currency in order to buy dollars and temper their currency’s appreciation relative to the dollar. The result has been lower U.S. bond yields and a super-charged global monetary policy.

Next week, it looks like the Fed will take us to an interest-rate extreme. All ears will be tuned to what the Fed has to say, and all eyes will be on the stock market.

— Mr. Malpass is the Chief Global Economist for Bear Stearns.