The Fed Should Do Nothing
Greenspan & Co. should listen to markets instead of trying to control them.


Larry Kudlow

The bond market is in full revolt from Alan Greenspan’s perverse, web-spinning circumlocutions. The maestro waved his magic wand toward lower rates, but rates went up instead.

The maestro says the Fed won’t tighten for a long time, but futures markets are forming a different view. The widely-tracked fed funds futures curve suggests election-cycle tightening moves next March and May that would amount to a 50 basis point rate hike in the spring of 2004.

While the Defense Department has abandoned its plans to sponsor a terrorist futures market, bondland was terrorized in July as Treasury prices got slammed and yields rose by 125 basis points or so.

But there is a silver lining. Market-induced rate increases are really signaling faster economic growth, not higher inflation. The fact that bond rates went up after the Fed pushed its short-term target rate down last June is actually a good thing. It signals that the central bank has added enough money to end the deflationary drag on the economy.

Bond mavens obsess over every nuanced statement from Greenspan & Co., but the reality is that information-encompassing markets are much smarter than the Fed. For example, markets realized full well that across-the-board tax-cutting would create new supply-side incentives for faster investment and demand-side inducements for consumption.

The big tax-cut bill was signed in late May. The Fed eased in early June. Market interest rates jumped up in July. Positive economic signs are now proliferating: retail sales, durable-goods orders, rapid productivity, higher profits, and lower unemployment claims. The huge stock market rally during the spring quarter had already discounted this.

So interest rates are now adjusting to more normal levels associated with stronger growth. During the boom in the back end of the 1990s, the 10-year Treasury averaged 6 percent while growth registered more than 4 percent, virtually without inflation. Today bonds are less than 4½ percent, still very low historically.

Because markets are smarter than governments — including central banks — Greenspan & Co. should stop trying to control or jawbone market rates. It’s a futile exercise that is more destabilizing than stabilizing.

Instead the government bank should let real-time markets be their guide. After closely tracking market trends for gold, commodities, bonds, and foreign currencies, the Fed should make periodic adjustments to its money-creating operations. This approach is known as a price rule.

The goal of a price-rule approach to money is simple: keep prices relatively stable. Avoid inflation or deflation. The Fed controls the volume of new money, and money is the most important influence on prices. Steady prices, meanwhile, promote economic growth.

The Fed should not fine-tune gross domestic product, or unemployment, or stock markets, or bond yields. This sort of interventionist central planning is disastrous for the economy.

Right now the market message is quite clear: money is sufficiently accommodative. So the Fed should do nothing. Almost anytime governments do nothing it is better than when governments do something. Now is definitely such a time.

Short-term interest rates will gradually follow bond rates higher over the next several years. But as the nascent recovery gathers momentum, there’s no need for new monetary adjustments right now.

Right now the effort to reflate the economy is proceeding successfully. Besides rising bond rates, dollar value has lost 25 percent relative to gold, commodities, and foreign currencies. More Fed fine-tuning of any sort is now completely unnecessary.

This is what the government bank should declare at their meeting today: Non-inflationary growth is on the way. Business investment and employment will improve. Price stability will continue. Rapid productivity gains will create a better economic scenario than almost anyone believes possible. There’s plenty of money to finance tax cuts and economic revival.

That’s all they need to say. If the Fed would listen to markets instead of trying to control them, then the public would be unusually well-served by a simple and clear policy statement that is understandable to everyone who holds a mortgage, owns a stock, works in a business, or stuffs greenbacks in their wallet or purse.

Mr. Kudlow is CEO of Kudlow & Co.