....The current recession is a direct result of policy choices made both by the Fed and by the Clinton administration. Fed interest-rate increases in 1999 and 2000, which pushed the real federal funds rate to its highest level in ten years, coincided with a peacetime record level of federal taxes as a share of GDP. In addition, regulatory hurdles created an energy crisis while zealous antitrust bureaucrats undermined high-tech creativity by attacking Microsoft.
When the Fed tightens monetary policy, overall spending slows. And in the past year, nominal GDP growth (real growth plus inflation) hit a wall. During the four quarters bracketing Y2K, nominal GDP grew at an average annual rate of 7.6%. During the four quarters ending in December 2001, nominal GDP likely grew by just 1.9%. Fed tightening squeezed the economy and created deflationary pressures.
Advances in technology have put more deflationary pressure on the economy. Consider the case of Ford Motor Co., which lost $1 billion in the fourth quarter on its holdings of palladium, which it bought for use in catalytic converters at over $1,000 an ounce in 2000. Palladium has recently fallen to below $400 an ounce.
While Ford should have hedged its inventory investment, the real problem was that it misunderstood deflation. Technology and Ford's own research labs were inventing catalytic converters that use less palladium. Hard as it is to believe, this technology-driven deflation still catches businesses off-guard. It also baffles the Fed, which followed an excessively tight monetary policy thinking that growth creates inflation even though non-energy prices remained stagnant.
Deflation naturally also showed up in retail prices, which were slashed by 50% to 75% this past Christmas shopping season, while auto manufacturers were forced to use zero-percent financing to clear inventories. Because consumers increased spending as prices were cut, it appears that the U.S. is not experiencing the kind of deflation that occurred in the 1930s or in Japan in recent years. But these massive price cuts nevertheless undermined profits and reduced investment.
Past performance aside, at least the Fed is finally on the right track. Interest rate cuts this year have pushed the federal funds rate down to a level close to inflation expectations. According to a University of Michigan survey, consumers expect inflation to average 1.8% in the year ahead. With the federal funds rate now at 1.75%, it appears that the Fed has done enough to end deflation and allow nominal GDP to accelerate again. Meanwhile, Mr. Bush's marginal rate tax cut last spring will help boost productivity despite the long phase-in.
In the next year, the economy will come to life again. But while the Fed and others will point to an inventory rebound, the wealth effect, and consumer confidence as the ingredients of recovery, the real reason will have been the policy shift. Consumers, investors and business leaders do not all change their minds simultaneously and shift from apathetic gloom to irrational exuberance or vice-versa.
The same rules apply for shocks like 9/11 or the collapse of Enron. A robust economy can withstand shocks like these with virtually no long-term effects. By December, three months after the attacks, the U.S. economy and stock markets had fully recovered. What's more, overall demand has returned to the exact recessionary level that would have existed if the attack had not occurred.
Fortunately, due to prescient tax cuts pushed by the Bush administration and a fortuitous shift in Fed policy, the economy is on the road to recovery. While the Fed denies its complicity and Democrats blame the president, the evidence is clear: Policy matters.
Mr. Wesbury, chief economist at Griffin, Kubik, Stephens, & Thompson in Chicago, was the most accurate economic forecaster in The Wall Street Journal's 2001 survey.
Updated January 30, 2002 12:31 a.m. EST
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