Last week, Alan Greenspan & Co. told us that the Federal Reserve’s monetary policy is “accommodative” to economic recovery, which in a perfect world would be a realistic assessment. Problem is, this is far from a perfect world.
While the Fed has been increasing the money supply at a roughly 10 percent rate in recent months, overall financial conditions in the economy have tightened — countering the Fed’s positive moves. In the wake of the Enron collapse, we’ve witnessed the unraveling of companies like Global Crossing, Tyco, Adelphia, and now WorldCom. Insider-trading probes have ImClone plunging and Martha Stewart Living Omnimedia teetering. In the media sector, Vivendi and AOL Time Warner look shaky. Bristol Myers and Xerox are feeling the pinch. And the list goes on and on.
This year’s crash-and-burn of major U.S. companies has been a deflationary event, one that’s taking a toll on the financial system and the economy. It has caused a major decline in individual wealth, net balance-sheet worth, and asset values. Major banks like JP Morgan Chase and Citigroup are stuck with nearly worthless paper and slumping earnings. Venture-capital funds are still dormant. The market for initial public offerings, which was struggling to reopen, is now again closed.
The only really prosperous market in recent months has been Treasury bonds, which have benefited from dropping interest rates. Yes, this may be fortuitous for home loan mortgages, but this kind of interest-rate decline among credit-risk-free government securities is representative of a new bout of temporary deflation.
Some have suggested the Fed made a mistake in March when it shifted its policy bias to neutral (meaning it would make no adjustments to the key fed-funds interest rate) from its earlier recession/deflation-fighting stance (meaning it would cut rates to stimulate the economy). Given the unexpected deflationary decline in stock averages this year, the central bank might want to consider reentering the fight. The door should be left open for the possibility of another easing move. At the very least, the central bank should reassure the public that the money-injection spigots will be left open wide.
The fed-funds futures market has already figured in some rate-cutting. CNBC’s Bill Griffeth has observed that the shift in fed-funds futures from a 3½ percent expected target rate by yearend to the current 1¾ percent target rate reflects a de facto tightening in the credit market. This is a good point. If corporate treasurers and bank-loan officers are pulling back from expectations of brighter financial conditions, there is in fact a mild internal tightening going on in the financial system. Greenspan should think about following their lead, because time may be running out.
In March of this year, the stock market hit its post-9/11 war peak. Since then it has dropped 15 percent, losing about $1 trillion in household wealth, and it has been accompanied down by an interest-rate decline in Treasury notes. In normal circumstances, a falling interest rate for Treasuries would be a plus for shares, but at the moment wealth and assets are contracting. This is a deflationary pattern, not a stimulative one. The $12 drop in gold is also symptomatic of the new whiff of deflation.
If Treasury rates and stock averages continue to descend, it will set off alarm bells over the health of the economic recovery. And then we’ll be left with a battle of perception. Should investors follow the stock market down, or the economic indicators up? Remember, there’s still a lot of good economic news out there. While consumer spending has slowed in this year’s second quarter, the pick-up in industrial production and shipments of durable goods suggests that the business-investment sector is in fact recovering. As this business recovery takes hold it will translate into higher incomes and hence more consumer spending. These are the true recovery forces, and they’re alive and well. But this rising-economy data is disconnected from the reality of falling stocks. It’s a disconnect that can’t go on forever.
Last week, we also heard from President Bush, who showed some welcome anger over the collapse of corporate ethics. Poll after poll clearly shows that the public gives Bush high marks on ethics and morality — a bit different from the marks Clinton received in his final years. If Bush can keep the White House on this message, he can successfully use the bully pulpit to restore a truly moral climate in the business and financial worlds.
Ending the moral amnesia in the executive suites will go a long way toward restoring investor trust and terminating the stock-market bear. But Greenspan has to remain on guard. These days, status-quo “accommodative” just won’t do.