Politics & Policy

The Fed’s Last Hurrah

Greenspan & Co. are locked in a Keynesian time warp.

With the market priced for at least a 25-basis-point reduction in the federal funds interest rate, what the Fed says on Wednesday actually is much more important than the interest-rate action itself. Size does matter, but in this case what matters most is what the Fed says. Based on the musings of various Federal Open Market Committee (FOMC) members, it is reasonable to assume that the Fed’s statement will prove to be more interesting than the size of the rate cut.

The FOMC will probably say that even though growth remains below potential, officials continue to expect an economic pickup in the months ahead. This is likely to accompany an additional warning that a further fall in already low statistical inflation would be an unwelcome event, with the committee stating that the risk of deflation offsets that of inflation. Perhaps the Fed will even insert some wording about not having run out of ammunition, even with the federal funds rate as low as it is, as the New York Desk has an unlimited capability to monetize debt regardless of the level of the nominal funds rate.

The entire exercise is rather ironic, as it was the Fed’s own tight-money policies from 1997 to 2001 that resulted in a 30 percent rise in the value of the dollar against gold and commodities. This caused economy-wide pricing power to vanish, resulting in a 50 percent plunge in reported earnings. A stock-market collapse and recession followed.

Now, with deflation risk rendered obsolete by the dollar’s 21 percent fall against gold and foreign currencies since early 2002, the FOMC has begun to worry about deflation. Someone on the House Banking Committee should ask Fed Chairman Alan Greenspan if there has ever been a country in the history of the world that experienced monetary deflation with its currency falling against gold, commodities, and foreign exchange. The bottom line is that Greenspan and the rest of the FOMC are ignoring market-based price signals (which read reflation not deflation) and are instead fretting about weak growth giving birth to a deflationary monster.

Why has this happened?

Well, in large part because the Fed’s intellectual guideposts are based on outmoded theories such as the supposed positive relationship between growth and inflation and its evil twin, weak growth and declining inflation (or deflation). In the Fed’s Keynesian demand model, this is referred to as a negative output gap. According to textbook Keynesian theory, if the negative output gap continues over an extended period of time, it places downward pressure on prices and wages — deflation. There is also another name for this: the Phillips Curve, which purports to show an inverse relationship between inflation and unemployment but has been an utterly useless forecasting tool since the 1970s.

Once the so called “negative output gap” gives way to more robust growth (most likely in the next two or three quarters), investors who own long eurodollar futures contracts and zero-risk Treasuries are going to get scalded. In other words, a strong recovery likely would upset the incredibly dovish interest-rate expectations now priced into bond yields and eurodollar futures contracts. When this happens, what is left of the “Fed panic premium” will be removed from bond prices, sending yields up. Since there already is a gigantic gap between long and short Treasury rates, long rates will rise less than short rates over the course of the coming expansion.

Rising market interest rates will be a sign that the economy is responding to a non-deflationary dollar and higher after-tax returns to capital and labor. A simple regression model shows a high correlation between junk-bond yields and real GDP growth three to four quarters out. The model works because junk-bond yields are a good proxy for market-wide risk tolerance. When investors tolerate more risk, investment rises and growth improves. When economic actors shun risk, investment collapses and growth stalls.

Junk-bond yields (and spreads) foretold the 2001 recession and provided an early warning that the economy was stalling out in the second half of last year. Right now, junk-bond yields are trading at levels associated with headline growth accelerating to 5.5 percent or higher by the middle of 2004. This would be bullish for corporate profits, capital spending, inventory building, and GDP-sensitive sectors and stocks. It would also be bullish for President Bush.

Democratic presidential contenders, now uniformly embracing the repeal of pro-growth tax cuts, are setting themselves up for a repeat of the Walter Mondale debacle of 1984. A more-than 5 percent growth economy next year would also be bearish for the credibility of the Fed, which remains locked in a Keynesian time warp and is unable to gauge the limits of monetary policy with a dollar that is no longer in deflationary territory.

— Michael Darda is the chief economist of Polyconomics, Inc., an economic forecasting firm located in Parsippany, New Jersey.


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