Time to Print Money
By John H. Makin
On November 6, the Federal Reserve surprised markets with a rate cut of 50 basis points (half a percentage point), lowering the federal funds target to 125 basis points, the lowest level since 1958. The most remarkable aspect of the Fed's action was not that the cut was twice as large as markets had expected but that, during the days following the move, markets behaved as if it had not been large enough. On November 7 and 8, the stock market fell by about 3 percent, while yields on ten-year treasuries fell by 25 basis points. Meanwhile, the dollar weakened by nearly 2 percent.
Markets Signal Weaker Growth
The Fed's action and the markets' unexpected response strongly suggest that fears of deflation and lower growth in the United States are becoming more intense. First, one cannot explain a sharp drop in long-term interest rates simultaneously with dollar weakness without acknowledging an underlying cause of expected lower inflation and lower growth. The dominant prospect has to be lower growth and lower expected real returns on U.S. investments. If the weaker currency following a Fed easing were signaling higher expected inflation, then U.S. interest rates would be rising as they were during the period of dollar weakness in the late 1970s.
The weaker stock market also provides strong evidence that markets are looking for lower U.S. growth and lower inflation or even, in some sectors, deflation. Without this view, it is hard to account for the failure of stocks to rally in the period immediately following two pleasant surprises: the larger than expected rate cut by the Fed and the Republican victory in the Senate, which increases the chance of stimulative tax cuts next year.
Fed Sends Contradictory Signals
The Fed may have complicated the task it faces with the confusing message in the policy statement accompanying the 50-basis-point rate cut. While markets are fretting, as the target Fed funds rate approaches zero, that the Fed may be running out of bullets to fight deflation and recession, the Fed's November 6 policy statement in effect expressed confidence that it would not need to use any more rounds. In returning to a neutral bias, in which the risks of inflation are seen as equally balanced with the risks of lower growth, the Fed's Open Market Committee said:
"In these circumstances, the Committee believes that today's additional monetary easing should prove helpful as the economy works its way through this current soft spot. With this action, the Committee believes that, against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the risks are balanced with respect to the prospects for both goals in the foreseeable future."
The Fed's response to strong signs that the U.S. economy is heading back into recession was akin to a move by a trainer of tightrope walkers to make his students work without a net before they are confident that they can avoid a deadly fall.
Demand Growth Weakens
Indeed, the U.S. economy looks as though it may well be falling from the high wire of a sustainable economic recovery. The dreaded scenario that the Fed has been trying to avoid, wherein U.S. consumption growth slips before investment recovers, is emerging clearly. During the third quarter of 2002, U.S. investment growth remained lethargic at virtually zero, while in September weakening durable goods orders suggested that it may well turn negative again in the fourth quarter. Meanwhile, U.S. real consumer spending has slowed sharply over the last several months. During the three months ending in October, U.S. real consumer spending fell at an annual rate of 1.7 percent, after having risen strongly at an annual rate of 5.2 percent from May through July. The bulk of this sharp drop in consumer spending is attributable to much lower spending on automobiles during September and October. Strong auto sales in July and August accounted for more than half of the 3 percent growth rate reported for the third quarter.
The Fed has been right to aim for an investment recovery to help mitigate and ultimately to reverse a slowdown in consumption spending. Under the current scenario, a sustained slowdown in consumption spending represents, along with weaker investment spending, a further drop in demand growth in the U.S. and global economies. Both economies have been relying on the strength of U.S. demand growth for most of this year, and weaker consumption in the United States therefore accentuates the deflationary tendency emerging in the global economy. Specifically, slower consumption growth will weaken the outlook for profits and thereby depress stock prices. As companies attempt to maintain profits in the face of a shrinkage in overall nominal spending, they will probably make further layoffs, since labor accounts for two-thirds of expenses for most companies. Increased layoffs could depress consumer confidence and lead to a sharp contraction of consumer spending, especially by households that have taken on additional debt to participate in the strong real estate sector. That is, the further job losses could depress consumption more, thereby building deflationary momentum.
The dollar weakness that intensified with the Fed's sharp interest rate cut is also troubling given what it implies for the U.S. economic outlook and that of the global economy. A weaker dollar means that the U.S. exports deflation. In 2002, such an export of deflation occurs in a world where demand growth is very weak and heretofore has been highly dependent on U.S. demand growth.
It is time for global policymakers to face reality. A necessary condition for the U.S. economy to recover may be the reflationary impact of a weaker dollar that shifts demand onto U.S. capacity. If that is the case, the world's other two major central banks--the European Central Bank and the Bank of Japan--will have to choose between additional deflation from a weaker dollar (a strengthening of their own currencies) or aggressive monetary easing on their part to help counter the deflationary impact of appreciation of their own currencies. The latter alternative would be highly appropriate given the weak state of demand in the global economy, as it would mean that all three central banks would be undertaking reflationary strategies in a deflationary world.
Fundamental Shift in Fed Strategy
In fact, we are fast approaching the time, indeed we may have already passed it, when the Fed and other central banks have to contemplate a fundamental shift in strategy away from interest-rate targeting and toward money-supply and price-level targeting. There is a clear precedent: when the Fed abandoned interest-rate targeting in favor of a focus on the money supply and price levels in October 1979, at the beginning of Paul Volcker's term as chairman. Up to then, higher interest rates engineered by the Fed had failed to stem the inflationary pressure that had built up during the 1970s. So on Saturday, October 6, 1979, the Fed's new chairman, boldly and publicly laid out a new strategy whereby the Fed would no longer target interest rates, but rather would target a level of money-supply growth consistent with price stability, while letting markets determine interest rates. In effect, Chairman Volcker was saying that the Fed was going to print money in a manner consistent with a move toward price stability and allow interest rates to take their own path.
The Fed's experiment in targeting money supply resulted in highly volatile markets, with short-term interest rates first rising into the early part of 1980, then plunging, and then rising again sharply during 1981, until settling down in mid-1982. Ultimately, the strategy change to monetary targeting brought U.S. inflation and inflationary expectations well under control and set the stage for the extraordinary bull market in equities that began in August 1982.
In 2002, the Fed should be contemplating a "reverse-Volcker" move. It should abandon interest-rate targeting, which will be futile in any case if it requires more than another percentage point of cuts in the Fed funds rate. It should adopt money-supply targeting consistent with the resumption of stable inflation between 2 and 3 percent. It is far better to undertake the shift in monetary policy strategy early, before the central bank is forced to cut its target interest rate to zero, because that reduces the chance of a deflationary liquidity trap such as that currently plaguing Japan.
Targeting money supply and price levels is the right strategy for a central bank to adopt over the long run and currently has the additional attraction that it avoids targeting interest rates during the period when the interest-rate target consistent with growth may be negative and therefore unattainable by the central bank. To put the same point another way, the risk of arriving at a situation where the central bank pushes its policy interest-rate target to zero and still faces deflationary tendencies is growing. That risk is simply unacceptable given the deflationary low growth tendencies in the rest of the world.
Price-level targeting has already been adopted by some major central banks, most notably the Bank of England. The instrument for achieving price-level targets may be the central bank's interest-rate target or its money-supply-growth target. But at a time when the interest-rate target may have to be negative to relieve deflationary pressures, targeting the money supply and price levels is the only appropriate course.
Central banks are perhaps uncomfortable with money-supply and price-level targets, especially in a period of incipient deflation because, in effect, the central bank is trying to convince households and businesses that prices will be higher next year than they are this year and so that hoarding cash is not a good strategy. Clearly, creating expectations of higher inflation is a bad policy when inflation is already running at an unacceptably high level. But it is the right policy when deflation threatens.
A central bank that adopts money-supply and price-level targeting to end deflation can and should set a well-defined range for the inflation level implicit in its strategy. Most central banks find that a 2 to 3 percent inflation target is a good one because it avoids getting too close to zero--which is important given the measurement problems associated with measuring inflation--while keeping actual inflation at a rate well below a level that ultimately might require drastic central bank action to reverse.
A New Fed Chairman?
For the Fed to implement a new strategy of targeting money growth instead of inflation may or may not require a new chairman. Chairman Greenspan has displayed great virtuosity and flexibility in managing monetary policy in the context of the dynamic economy that we have seen since his term began in 1987. However, Greenspan, in public at least, has resisted urging that the Fed consider a price-level or inflation target using money growth as an instrument in place of an interest-rate target. However, if signs emerge that the U.S. economy is returning to sharp recession--specifically, slower consumption and additional layoffs--it would be unwise for the Fed to delay serious consideration of a fundamental change in strategy toward inflation targeting, using money-supply growth as an instrument in place of an interest-rate target. |
