Staying Loose
The Fed should be in no rush to raise rates.
By Larry Kudlow
The Federal Reserve is all set to choose employment over the dollar in guiding their open-market decision today. That means no change in the fed funds interest rate. It may also mean little or no change in the Fed policy statement.
The central bank is straddling their traditional Keynesian Phillips-curve tradeoff between unemployment and inflation, or growth and inflation. Since payroll jobs have registered a weak recovery so far, the low-interest-rate, easy-money scenario will continue.
The softening dollar relative to gold, commodities, and foreign currencies may be signaling a higher future inflation rate, but this doesn't seem to trouble the Fed. Forward-looking indicators are being shunted aside.
Frankly, with gold just over $400 and the 10-year Treasury just above 4 percent, it appears the Fed is doing the right thing. This is no Phillips-curve affirmation. It's just that price-rule indicators are not an urgent concern right now.
Today's 1 percent fed funds rate is about 80 basis points below the natural rate (proxied by the Treasury's 1.83 percent 10-year inflation-adjusted security, or TIPS rate). Whenever the policy rate is below the natural rate, money is relatively easy.
However, inside the money market, credit demands are soft. Highly profitable business has more than enough cash flow right now to deliver solid returns to investors and finance capital-equipment expansion without borrowing. Illustrating this, 3-month Treasury bills are yielding 0.91 percent with commercial paper around 1 percent. These borrowing rates would be much higher if upward interest-rate pressures were developing.
At some point the Fed will move policy into a more neutral position, but there's no rush.
There is a chance that Fed chairman Alan Greenspan is aware of all this. That he watches financial- and commodity-market indicators is well established. Whether he is using these indicators in formulating his policy view is more ambiguous. Perhaps the Greenspan Standard spans the price-rule and the Phillips curve. This would be a more benign explanation of the Fed's strategy.
Meanwhile, Fed governor Ben Bernanke prefers a core PCE deflator price rule (the PCE deflator being a calculation of price changes in personal-consumption expenditures) rather than a straight, real-time, fast-forward, market-oriented rule. The consumer-spending deflator is backward looking, although in the new world of high-speed information processing, it may not be quite as backward-looking as in previous cycles.
In any event, the Bernanke Rule suggests that a bit of excess money in the economy is okay, since inflation is virtually non-existent.
The degree of excess money is hard to pinpoint exactly. But lower tax rates, higher productivity, and more-rapid economic growth will absorb excess liquidity and significantly diminish the inflationary potential of that liquidity. Easier tax rates and easier money remains the correct policy prescription to turn deflationary recession into reflationary growth.
This is clearly the message of the roaring stock market, where even interest-rate-sensitive sectors are performing well. So stocks are not predicting a new wave of higher interest rates.
That said, when should rates rise? On one side of the debate, hard-line price rulers want higher rates right away. On the other side, soft-line Phillips-curve tinkerers say no rate hike till 2005.
Euro-dollar futures anticipate a 25 basis-point rate hike in August, followed by another 25 to 50 basis points in November and December. This middle-of-the-road scenario seems to be the most reasonable.
The economy certainly agrees that interest rates, for the time being, are fine where they are. Real domestic private-sector GDP increased 3.4 percent in 2002 and 4.4 percent in 2003. But the true inflection point for economic recovery occurred last spring, following the Bush tax cut and the Fed's (last) rate reduction to accommodate it. So, in truth, this young recovery is even younger.
It's too soon for the Fed to take action. |
