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.
No matter what the investment — be it corporate profits paid out as dividends, or capital gains, or new capital-goods orders and shipments by large and small businesses, or new high-risk venture start-ups — higher after-tax investor-class returns will place new liquidity demands on the financial system. The Fed must accommodate them.
A shock-and-awe liquidity-expansion policy from the Fed will counter our underperforming economic recovery, offset the forces of worldwide deflation and recession, and stomp out deflation fears at home. An aggressive liquidity stance will also accommodate rising transaction demands following the latest Bush tax cut. And it will even counter the negative effects of any potential breakdowns in the investment portfolios of Freddie Mac and Fannie Mae, the troubled loan institutions.
Deflationary interest rates are making this very same case. Last winter, the bellwether 10-year Treasury note yielded around 4 percent. Today it is slightly over 3 percent. In the money markets, euro-dollar and fed-funds futures have all risen to new contract highs, thereby pricing in a 50 basis-point cut of the Fed’s interest rate.
In commodity markets, early year rallies for basic metals and industrial materials have stalled. Even gold prices, the strongest reflation indicator so far, have slipped in recent weeks.
The Fed should follow these real-time financial- and commodity-market indicators. Liquidity-sensitive market prices are signalling that the economy is still soft and that lingering deflation remains a threat to future growth. In fact, business durable-goods prices continue to fall at a 2 to 3 percent rate, on average.
Broad-based government price indexes may be registering zero inflation, but people like Ben Bernanke, a new Fed board member, and Glenn Hubbard, the president’s former top economic advisor, have sensibly argued for a 2 percent inflation target. Meeting this objective would require sustained reflationary policies, not stand-patism.
Over the past two years, an output gap — the difference between actual and potential GDP — has opened up to roughly $500 billion. The three-quarter-long recession in 2001 deserves much of the blame, but so does a sub-par 2 percent economic recovery since then. Continued 2 percent growth will widen the output gap, raise unemployment further, and guarantee that budget deficits at the federal, state, and city levels continue to expand.
The most hopeful economic indicator has been the stock market. The Wilshire 5000 index of all actively traded stocks has climbed by roughly 30 percent since last October 9, adding nearly $2.2 trillion to investor wealth. But stocks remain 35 percent below their prior peaks.
The National Association of Business Economists is now predicting 3 to 4 percent real economic growth over the next 18 months — another good omen, one with which I basically agree. But both the stock market and the more optimistic NABE economists are providing forecasts. And these forecasts are surrounded by more-than-usual uncertainty.
Some say that market interest-rate declines have already done the Fed’s work; no additional central bank actions are necessary. But the key measure of Fed policy is not their short-term interest-rate target, but the volume of new cash they put into the economy.
That’s why recent statements by Alan Greenspan and his vice chairman Roger Ferguson sound encouraging. They have suggested that the Fed could purchase 10-year Treasury bonds — even if this reform is only temporary. Here, too, the issue is not the Fed’s theoretical control of interest rates. World credit markets — not the U.S government — set rate levels. Instead the issue is conducting open-market operations through 10-year bond purchases, which will pump in new cash just as readily as the Fed’s more normal method of buying Treasury bills.
We must not risk another disappointment in the stock market or the economy. That would be devastating. Mr. Greenspan and all his little maestros need to pour it on. This is no time to take chances. Add more money. Do whatever it takes to get America humming again. Supply-side tax cuts set the stage for strong economic growth. But it’s up to the Fed to show us the money.
— Mr. Kudlow is CEO of Kudlow & Co.