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A Moving Target?
The Fed could come out of its policy box.


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Larry Kudlow

The Federal Reserve could announce some out-of-the-box policy thoughts on Wednesday, ones that would add recovery fuel to the reflation of price indexes, especially business-pricing-power measures. But they have to depart from their ingrained, hide-bound, and Keynesian-based stodgy ways.

Many supply-siders believe that reflationary forces released by Fed liquidity additions over the past year are sufficient. While I acknowledge the rise in commodities, including gold, and the easier dollar — all of which comprise forward-looking market-price indicators signaling a shift from deflationary money to reflationary money — I still believe more can be done to insure that lingering deflationary pressures are completely stomped out.

What’s more, as gold slips back to $346, I remind my classical colleagues that the biggest reduction of investment-oriented tax rates since the founding of the Republic requires even more cash injections from the central bank in order to accommodate stepped-up transaction demands resulting from the sizable increase in after-tax capital returns, as well as the considerable drop in the cost-of-capital hurdle rate for businesses both large and small.

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Instead of targeting a lower federal funds rate to offset the so-called output gap — that is, the roughly $500 billion deficit between actual and potential real GDP — the Fed could theoretically leave the fed funds rate alone and state that they have no intention of tightening policy for the next twelve months.

Instead, in order to wean themselves off funds-rate targeting — which tends to destabilize the economy more often than not — the central bank could announce that henceforth it would conduct open-market operations through the purchase or sale of Treasury notes and bonds.

In current circumstances, the bank would add reserves through the purchase of 2-year, 3-year, 5-year, and 10-year notes, and even 30-year bonds, until commodity price indicators rise another 10 to 20 percent. Presumably this additional commodity rally, again including gold, would move broad-based domestic inflation indexes toward 2 percent, a benchmark suggested by Ben Bernanke of the Fed and former Bush adviser Glenn Hubbard. That 2 percent would be consistent with domestic price stability (in view of price-index measurement errors).

The Fed already buys a lot of notes and bonds, though not one analyst in a thousand pays any attention to this. In fact, notes and bonds comprise roughly 60 percent of the Fed’s investment portfolio, with Treasury bills absorbing a bit less than 40 percent. The remainder consists of a small amount of inflation-adjusted TIPS (Treasury Inflation-Protected Securities), along with a few other cats and dogs.

Year-to-date, notes and bonds in the Fed portfolio increased at a 5½ percent annual rate, while Treasury-bill additions expanded at an 8 percent pace. Overall, Treasury holdings have expanded at an 8 percent annual rate over the first half of the year. This strikes me as a bit less than necessary; I would suggest stepping up portfolio additions, which comprise the bulk of the monetary base controlled by the Fed, to something around 10 or 12 percent.

In other words, the Fed can do it because they have been doing it all along.

Most important, the Fed would decontrol the overnight fed funds policy rate by focusing on note and bond purchases. From overnight to 30-years, markets would set interest-rate levels.

The thrust of monetary policy would then shift to a new price rule model, rather than the old fed funds rate targeting model. Forward-looking market prices would serve as an intermediate target, with broad-based price indexes as the longer-term ultimate target.

Ironically, if the Fed creates excess reserves, then market interest rates would probably begin to rise, not fall. This would be an important economic-growth signal. Driving a market-rate rise would be an increase in investment returns as revealed in rising inflation-adjusted TIPS rates, which are presently about 1½ percent, but should rise to around 4 percent in a healthy economy with at least modest business pricing power.

Supply-siders are more concerned with the demand for money, or velocity, rather than the money supply favored by monetarists. The rate at which money changes hands in the economy continues to decline, however — and that’s a negative sign for economic growth. In fact, velocity in the past two quarters has actually declined a bit more than in the previous couple of quarters.

Recent velocity declines may help to explain the slowdown in commodity indexes. The Journal of Commerce indexes for metals and industrials had been growing at a 15 to 20 percent rate earlier this year, but recently they have slowed to about 3 percent.

Those two indexes remain 20 to 25 percent below their 1996 peaks, a period in time characterized by roughly 2 percent core inflation. Non-financial business output prices are currently hovering around zero, while durable hard goods prices are still deflating by 3 percent. Heavier liquidity-adding by the Fed would bring those prices into positive territory, providing impetus for stronger profits and job-creating production.

The likelihood of a Fed paradigm shift to a liquidity-based price rule is, unfortunately, almost nil. That is why new blood at the top of the Fed would be a very positive development for reform.

But the key point in all of this is that however the Fed chooses to do it, more high-powered cash to insure an end to deflationary threats and a sure-footed beginning to strong economic recovery is the most important priority.

Washington has provided the tax cut incentives to generate 5 percent growth. Now it is up to the Fed to adequately finance the coming investment surge by showing us the new money.

Mr. Kudlow is CEO of Kudlow & Co.



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