In the wake of the problems in the financial sector caused by the sub-prime mortgage meltdown, market analysts are expecting the Federal Reserve to again reduce its key benchmark interest rate — the federal funds target rate — when it meets on December 11. Citing “headwinds” for consumers, Federal Reserve chairman Ben Bernanke has strongly hinted that a rate cut is forthcoming.
But does the U.S. economy really need more liquidity right now?
The best way for the Fed to determine whether there is too much or too little liquidity in the economy is to use inflation-sensitive, forward-looking market-price indicators as a policy guide, what supply-siders call a price rule. Real-time market-based indicators such as the U.S. dollar exchange rate, commodity prices, and long-term interest rates — viewed in conjunction with one another — provide the most reliable signals about both the demand and supply of money. In the late 1980s and early 1990s, former Fed vice chairmen Manuel H. Johnson and Wayne Angell were successful in encouraging the Greenspan Fed to focus on these inflation-sensitive indicators, thus ushering in the era of low inflation and economic growth.
Supply-siders believe that the Fed should conduct monetary policy on the basis of tangible market-based signals, instead of an ad-hoc, economic-fine-tuning approach. Today, those market-based indicators are, at best, inconclusive about whether the Fed should ease. On the one hand, the long-bond is down and the yield curve is inverted, which suggests that the Fed may be too tight. On the other hand, key commodity prices such as gold, silver, and especially oil remain high, while the dollar exchange rate has declined, suggesting that there is adequate liquidity and that inflationary pressures remain.
After looking at these real-time, market-price indicators, economists Brian Wesbury and Bob Stein of First Trust Portfolios have concluded that rather than too tight, the Fed is just less loose, and that an “aggressive Fed easing will push commodity prices even higher and the dollar lower.” Economist David Gitlitz of Trend Macrolytics hits the nail on the head: “The problem is that ultimately there’s a price to be paid, and the indicators we follow most closely — including gold near all-time highs and the dollar near record lows — suggest that the price will ultimately prove substantial in terms of higher inflation and the policy response that will be required to contain it.”
To be sure, after six years of expansion, most economists predict the economy is likely to slow down, but fall short of a recession. According to Council of Economic Advisers chairman Edward Lazear, “We are entering a record fifth year of continuous job growth while the unemployment rate remains low and we believe that these trends will continue.” The credit shocks caused by the turmoil in the sub-prime market could hurt economic growth. But the Fed has already taken appropriate action to ease the credit crunch by liberalizing its discount-window lending policy.
Instead of pushing the Fed to unnecessarily cut interest rates, Wall Street investors, the media, and others should put the onus on Congress to boost the U.S. economy by cutting tax rates. Making the Bush tax cuts permanent, especially the capital-gains and dividend tax reductions which are set to expire by 2010, would lift the cloud of economic uncertainty. Cutting the U.S. corporate tax rate — currently the second highest among industrialized nations — would not only improve the cash flow and profitability of U.S. firms in the near-term, but greatly enhance their ability to compete in the global marketplace over the long-term. At the very least, Congress should refrain from raising taxes. Enacting personal accounts for Social Security and reforming runaway entitlement spending would reduce government’s growing share of the private economy. All of these steps would make America a magnet for investment and strengthen the value of the U.S. dollar.
The bottom line is this: The Fed must keep its eye on inflationary pressures and resist unjustified interest-rate cuts. Washington policymakers must act now to cut taxes and rein in government spending in order to create an unambiguous future environment for economic growth.