At this week’s Federal Reserve meeting the benchmark policy rate was held at its lowest level since 1958, and according to the Fed’s policy statement it will remain there for “a considerable period.” The stock market cheered loudly on this news. But the wording of the Fed’s statement did little to prepare markets for the growing likelihood that the federal funds interest rate and other market rates will rise next year.
Right now, election year or not, the fed funds futures market is predicting quarter-point rate increases next May and June. Euro-dollar futures anticipate a 21/4 percent funds rate by December 2004 (the overnight rate is now 1 percent) and a 31/4 percent target rate by December 2005.
Ultimately markets will process information on the economy and inflation to make their own judgments about interest rates. But there currently seems to be a big debate inside the Fed over how much the central bank should attempt to use public statements to manage interest-rate expectations. Last spring, remember, the Fed’s attempt to jawbone long-term rates backfired — the 10-year Treasury note went up about 150 basis points, a full-scale revolt against the Fed’s suasion. Undoubtedly there’s an important lesson here: Don’t try to fool financial markets, they’re bigger than you are.
No matter what the Fed says, if the economic recovery continues to register a strong 4 to 5 percent growth rate in the next two quarters — following the consensus estimate of 6 percent for third-quarter gross domestic product (to be released Thursday) — interest rates will be rising next year.
The 10-year inflation-adjusted rate (or the so-called natural rate) is now hovering around 2 percent. This is way below normal; it will adjust upward by at least a percentage point in the next year. Much of this upturn in the real rate will come from stronger-than-expected business investment. Lower tax rates on capital formation (dividends and capital gains) and faster tax write-offs for business purchases of capital-goods equipment will promote higher investment returns and greater credit demands, all exerting an upward bias on interest rates.
Though commodity prices have been booming and gold is at the upper end of its safe-haven range, inflation expectations currently don’t look like much of a serious threat. Over the past year the Fed has done a good job of reflating the economy and stabilizing core producer- and consumer-price levels.
In addition, some of the big gains in industrial commodities have come from rising economic demands from China and therefore do not represent excess liquidity that might be turned into future inflation. Money supply has been moving erratically, but the Fed’s balance sheet keeps expanding at a healthy 10 percent rate. All of this suggests that there is no need for preemptive restraining moves by the Fed. That seems to be the main point that Alan Greenspan wishes to communicate to financial markets and investors. At this stage he is surely right.
So the central bank should keep it simple — or as they say in management seminars: Keep it simple, stupid. The Fed does not need multiple risk assessments of numerous economic targets. All that went out with the demise of Soviet central planning.
If the Fed wants true glasnost in their public communications, they should release policy-committee minutes immediately after they meet. Or, the chairman should hold a news briefing and take questions from the media right after a policy meeting concludes.
Next year, the big surprise for both Fed officials and the public will be the durability of stronger economic growth. Keynesian demand-siders believe that the one-time effects of this year’s tax cut are already wearing off. But supply-siders recognize that a permanent reduction of tax rates on business and investment will continue to provide capital-formation incentives — investors will take more risks and businesses will spend more on capital goods. Small businesses, meanwhile, will continue to benefit from lower personal income-tax rates.
Allowing people and companies to keep more of what they earn and invest will produce a stronger economic growth rate for the next several years (as powerful productivity gains generate higher profits and wages). Consumer confidence will strengthen and job opportunities will broaden. The Fed’s role in this scenario is to accommodate the rising prosperity tide by steadily providing liquidity, even as interest rates gradually adjust to more historically normal levels.
So long as the central bank keeps a sharp eye on forward-looking financial and commodity market-price indicators as they guide money creation, we should experience an inflation-free bull market economy for as far as the eye can see.
— Larry Kudlow, NRO’s Economics Editor, is CEO of Kudlow & Co. and host with Jim Cramer of CNBC’s Kudlow & Cramer.