Yesterday’s Fed action to lower the federal funds rate by 50 basis points instead of 75 was a wuss move. Sort of like leaving a three-foot putt short of the cup. Nice stroke, Alice.
So stock markets hemorrhaged on the news, plunging almost immediately after the Central Bank’s announcement. Particularly bizarre was the announcement itself, which cited deteriorating economic conditions across the board. The Fed noted downward profits, falling investment, declines in stock-market wealth, weakening consumer spending, and a backup of inventories. The Fed also noted that economic weakness at home and abroad could continue for quite awhile. In other words, things look darkest before they turn completely black.
Yet, having acknowledged these problems, the Fed chose to move like Miller Lite, rather than applying a heavier brew. Alan Reynolds’ excellent piece in yesterday’s New York Post made a strong case that the economy may already be in recession. And he noted that in 1990 the Fed failed to detect recession until the downturn was already six months old.
Bolstering Reynolds’ case, a New York Fed model that uses inverted Treasury yield curves — meaning that short-term rates are higher than long-term rates, thereby signalling excessive monetary tightness — now predicts a 50% recession probability in this year’s third quarter, and a 60% likelihood of recession in the fourth quarter. In other words, instead of a second-half recovery, expected by Alan Greenspan and other Fed officials, a second-half recession could be in the cards.
This could be what the stock market’s dismal decline is telling us.
Meanwhile, the obsession over the Central Bank’s fed funds rate masks a more important shortfall in policy. Namely, the urgent need to pump more high-powered liquidity into the economy. Even at lower interest rates, the monetary base continues to grow sluggishly. This measure of the most basic money supply controlled by the Fed increased at a gargantuan 16% rate in 1999. But the Fed deflated the monetary base at a negative 2.5% rate in 2000. Such a swing from accelerator to brake is nearly unprecedented in monetary history.
Not surprisingly, it has deflated the stock market and the economy. The base rose briefly in January, but it has flattened out in February and March. Twelve-month growth in high-powered money currently stands at a paltry 3%, way below the financing needs of the economy.
Liquidity indicators such as weak gold, falling commodities, a very strong dollar, and an inverted short-end of the Treasury curve continue to throw off deflationary signals. Importantly, monetary-base growth in Japan and Europe show the same pattern as in the U.S. There is a global liquidity crunch and it is bringing down world stock markets and their economies. Where’s the G7 coordination to preserve international prosperity now that we urgently need it?
Immediate tax-rate reduction for personal incomes and capital gains would also be a great help. New incentives for growth and capital formation put in place this year, not five years from now, would revive badly sagging consumer and investor spirits.
Also, the Bush administration’s decision to stand idly by and passively accept new OPEC oil-production cuts is hard to fathom. The oil cartel apparently seeks $28 per barrel, whereas most industry observers believe $20 a barrel would be more normal. Additional energy-price declines would relieve the pinch on profit margins and restore lost purchasing power to the economy. But the Bushies are seemingly content to let this pass.
Turning back to the Fed, liquidity deflation will not end until year-to-year monetary-base growth increases by something like 10%. The Central Bank must bring its fed funds rate down below all the other Treasury rates, while it pumps in additional supplies of high-powered base money. This might mean a 3.5% funds rate. Importantly, the Bank will know it’s accomplishing its task, or replenishing liquidity, when the Treasury curve reverts to a normal upward slope. Gold should probably rise about $25 in the process, and other commodity indicators will stop falling.
Increasing monetary-expansion rates and reducing tax rates will revive the stock market and speed economic recovery. Tax cuts to fight the slump and monetary ease to end liquidity deflation are the necessary ingredients for the next bull-market prosperity cycle.