Now that President Bush has signed the most pro-growth and investment-oriented tax cut in 20 years — the stock market is up 500 points since Congress passed the bill — the focus of economic policy shifts to the Federal Reserve. The monetary priests next meet on June 25. Most supply-siders disagree, but Alan Greenspan & Co. should turn the money spigots wide open that day — more than they have thus far in this reflation cycle. I’m talking about shock-and-awe level accommodation from the Fed.
That’s the probability — and here are my reasons why such a rate cut should be a certainty.
For nearly three years the Fed has erred on the side of deflation. Now they must err on the side of reflation. The 50-basis-point rate cut last November was a decent beginning, but in the context of a deflationary slump worldwide the Fed cannot afford to take any chances. A revived stock market is signalling that a better economy is ahead. But we’ve had disappointments before, and that is why the central bank should take out an insurance policy of additional ease.
At today’s low rate levels, a half point cut from the Fed has much more clout. Indeed, lowering the federal funds interest rate from 1.25 percent to 0.75 percent would represent a 40 percent rate reduction — a move that would have more money-adding bang for the buck than generally understood.
Whatever the Fed’s decision, the key point is that liquidity creation is more important than interest-rate targeting. If I thought the Fed would add plenty of new money by purchasing 10-year Treasury notes — a move hinted at by Alan Greenspan in recent congressional testimony — then I’d say abandon the fed funds rate target altogether and just keep buying Treasuries until commodity prices, including gold, go up another 10 to 20 percent from current levels. That would tell us that the economy is well supplied with cash.
Today’s super-low inflation, which actually flirts with deflation, is a loud signal that more cash must be sent in. Right now broad price indexes are around 1 percent, and given the measurement problems of the government’s price indexes, actual inflation may be much lower than that. Just as inflation is caused by excess money, deflation results from a shortage. How to solve the deflationary threat once and for all? Inject more liquidity.
Glenn Hubbard, the president’s former top economic advisor, and Ben Bernanke of the Federal Reserve have a good solution. They say the Fed should be targeting a 2 to 2½ percent inflation rate — or, put another way, the central bank should add enough liquidity to reflate prices until this price target is reached. Again, figuring in the government’s faulty price measurements, a 2 percent inflation target would still represent domestic price stability.
And as the Fed reflates, all the major money-supply aggregates should grow at double-digit rates for the next six to twelve months, or until price target objectives are met. Presently, the various money measures — including the monetary base (controlled by the Fed), MZM (money at zero maturity), and M2 (a traditional measure that includes money-market funds and savings accounts) — are all growing around 7 or 8 percent year-on-year. This, again, is too low, because the rate at which money is changing hands inside the economy — called velocity — is still declining. This drop in velocity robs the money supply’s economic power. Hence, at least temporarily, faster money growth is necessary.
Finally, the Fed must provide enough cash to fund the new investment tax incentives just signed by President Bush. These incentives include higher after-tax returns for investor dividends, capital-gains tax relief, lower top personal income-tax rates, and faster business equipment expensing. These need to be fully financed if there is to be a complete recovery, including a traditional cycle of rising job creation and falling unemployment.
By the way, a strongly accommodative Fed policy that keeps the American economy flush with cash will force foreign money masters — like those in western Europe and Japan — to do the same. Otherwise the U.S. dollar will keep floating downward, putting foreigners at a big disadvantage. The Fed has a global responsibility to lead on reflationary money expansion. Then the international maestros will follow.
Back at home, the story is a simple one. Washington has done its job by bringing down tax rates. Now it is up to the Fed to show us the money.
— Mr. Kudlow is CEO of Kudlow & Co.