Should the Federal Reserve Aggressively Cut the Fed-Funds Target Rate?
The word from conservative economics commentator Larry Kudlow
By blackhedd Posted in Economy | Interest rates | Larry Kudlow — Comments (15) / Email this page » / Leave a comment »
I just happened to be listening to one of RedState's friends, Larry Kudlow. He has a Saturday-morning talk show on WABC-radio here in New York City. He has a lot of intelligent things to say about the potential policy responses we can make to the current economic situation, most of which I agree with.
He does recommend that the Federal Reserve aggressively reduce short-term interest rates. It's taken me longer than some people to come around to this point of view (the only-marginally sane Jim Cramer has been howling about this since August.)
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Expectations are widespread that the Fed's Open Market Committee will announce another 50-basis point cut in the Fed funds target rate at their next scheduled meeting on January 29. Larry said that Fed Chairman Bernanke should have announced a 50 basis point cut in his Congressional testimony this past week, in addition to the 50 we'll get at the end of the month.
I would have been darned surprised if Bernanke had done that. Central bankers in general, and Bernanke in particular, aren't generally given to bold action. It does have me thinking that we just might get a full percentage point cut at the FOMC meeting.
According to Larry, this would be enough to pull us out of whatever it is we're in right now. (It might be a recession. It might just be a financial-market panic. It might be a big pile of self-fulfilling prophecy. It might be all of the above.)
Cutting by a full gallon would take the Fed funds rate down to 3.25%. Among other things, this would un-invert the yield curve, given that the 10-year US Treasury note finished up again yesterday, to yield an incredibly low (my perennial description of this rate) 3.63%.
It would also (and Larry made this point too) have the effect of increasing the money supply.
There's a bit of subtlety to this which I think escapes many people, especially given all the mishugas we've had in this political year about inflation supposedly caused by not being on a gold-standard. As it turns out, growth in the US money supply has been stagnant for about two years now.
The open-market desk at the New York Federal Reserve Bank constantly adds to and subtracts from the money supply for a variety of technical and policy reasons, usually around 8:30 AM Eastern time on trading days. But if you examine their doings closely, you'll see that they very rarely make what are called permanent changes to the money supply. The last time they did this to my knowledge was in April 2007, well before last year's financial crises exploded into public view.
Cutting the Fed funds rate has the indirect effect of increasing the availability of lendable funds in the economy, so it has a similar effect.
But how low can the funds rate go, and how low should it go? More to the point, will lower short-rates help get the US economy back on a strong growth track?
The last cycle of monetary easing ran from 2001 to early 2004, with the Fed funds target rate bottoming out at 1%. Should we go back there? I think that would be well worth considering.
What's the downside risk? Well, regarding this point, I'm glad to see that Kudlow has been reading my posts at RedState over the last few months! He's a thousand percent right when he says that increasing the money supply is only a good thing to do if there is a productive place for the money to go.
Otherwise, you get inflation in one form or another. (During the 2001-2004 period, it found its way into asset prices rather than the more-traditional wage and consumer prices.) But as I said here yesterday, the risk of inflation is now judged by bond market investors to be essentially non-existent. Larry said much the same thing this morning on WABC-radio. Therefore there is a lot of room to cut rates.
And that unfortunately brings us to consider the political risks.
Have you ever tried to step on the gas pedal and the brakes simultaneously? You burn a lot of rubber and gasoline but don't get anywhere in particular.
Since the best currently-available information predicts a Democratic sweep in the November elections, we have to expect that next year will bring a raft of policies that will have the effect (if not the intention) of reducing the ability of businesses to grow the US economy.
That means that if we create a lot of additional liquidity now, by sometime next year it will stop finding productive, job-creating places to go, and start generating inflation (somewhere, somehow) instead. And thus will be laid the seeds of the next recession to follow after this one.
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from you.
"It is our choices that show what we truly are, far more than our abilities." ~Professor Dumbledore
Sometimes the economy just needs to work itself out. Inflation should be the primary focus right now. Keep interest rates where they are because people spending and borrowing is what got us into this current mess.
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Notice to All - I am an independent who has voted for Senator Bayh (Democrat) and Senator Lugar (Republican) along with over 60% of my state. You may take what I say with a grain of salt at your own party'
Most of the time when I watch the line of suits giving their economy up/down opinions on CNBC, I'm thinking...Ok, he has clients that are short, he has clients trying to get out, she's a politico hoping for a recession etc etc.
What the hell is going on out here? - Vince Lombardi
While I expect little support from Congress, I would prefer to see a stimulus package focused on marginal tax rate cuts, particular for corporations. I could suggest many simplification changes to go along with rate changes, but that would take a far longer response than I can muster here.
This would, as you and Kudlow say, give the money somewhere to go.
I am nervous about too much Fed action, even considering an inverted rate curve. I refer you to the lead editorial in today's WSJ. I believe one needs a subscription to view it, so I can't put an effective link. The following are the last few sentences:
"So what to do? Pass a tax cut that is immediate, marginal and permanent. In the "stimulus" grab bag that President Bush is contemplating, the only growth driver is bonus depreciation. Congress will be worse. As for the Fed, continue with the regulatory triage, but ease as little as it can get away with and slowly restore the monetary credibility that was so painfully earned in the 1980s."
I believe that is consistent with fair use.
Steve Willis
Professor of Law
University of Florida College of Law
No ifs, ands, or buts. But as I said in my post, the political risk is that we'll stay where we are now or even go in the wrong direction.
It's just so disheartening to see so many people who think that businesses are out to take food out of people's mouths. "Tax fairness" is one of the most self-defeating ideas I've ever heard.
But the subject of this post is monetary policy, not fiscal policy or tax policy. I don't often read the WSJ, so I can't speak to your point, but the usual objection to monetary easing is the inflationary potential.
As I said, inflationary expectations are currently muted.
My tax students and colleagues would hate it, but it is precisely what we need (which illustrates the political difficulties in achieving it). I apologize for going off topic, if that is what I did.
To further our agreement, current fiscal and tax policy discourage economic growth, forcing the Fed to rely on monetary policy alone. If - and the IF is probably insurmountable - Congress ridded us of anti-growth fiscal/tax policy, then the Fed's monetary policies would need to be less drastic, the money would have "someplace to go" and the risk of a dollar run and panic would be lower.
The point of the Journal article is in complete agreement with you . . . except that it further addresses the inter-play of monetary policy and fiscal policy. It argues that monetary solutions alone carries greater risk than the two together. We live, however, in the real world. The Fed can simply act. The political system cannot.
I will avoid another threadjack by not expressing any opinion on the political campaign other than this: I wish the candidates would address your points and the role of monetary policy. I further wish they would more clearly address how they could and would lead the political system to change fiscal and tax policy to ease the role of the Central Bank.
Thank you for an illuminating article.
Steve Willis
Professor of Law
University of Florida College of Law
At least two of the major Republican candidates just this month advocated cutting corporate tax rates, so you are simply wrong in asserting that Republican candidates are not addressing these points.
The trend was that Europe and the United States, starting in the 1980s, had been cutting their corporate tax rates in response to each other, and had the United States kept up with that trend in the 2000s, both sides of the Atlantic could have been projected to reach near-zero corporate tax rates not far off in the future.
The blame for relatively high United States corporate tax rates falls squarely on the shoulders of President Bush and Republican leaders in the House and Senate, all of whom failed to follow the Reagan example, instead choosing to pursue special interest tax breaks instead of across the board tax cuts that would have benefited everyone. Such an outcome was warned about as early as the year 2000 in articles such as this.
I'm assuming no such thing. Consequently, I'm taking a danger-avoidance and risk-mitigation approach to business and investment planning.
In English, that means don't invest in US assets.
I don't think wage data has been showing inflation. And it isn't an overheating economy that is driving up the prices of food and energy, where most of the inflation has been showing itself. Raising rates isn't going to have much of an effect in those areas. A stronger dollar would help, but not as much as the higher interest rates would hurt, I'd say.
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Underlying most arguments against the free market is a lack of belief in freedom itself. - Milton Friedman
(by cutting the federal funds rate) solve a problem largely brought on by cheap money and weak internal controls issuing mortgages and other loans?
If Ben cuts the rate 1/2% because the economy is slowing and the market droped 6%, what's he going to do if the market drops another 20%?
He'll be printing money until he runs out of trees.
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"Enlightened statesmen will not always be at the helm." -- James Madison
such drastic action is necessary. Up until the last jobs' report, I took this contrarian view of the economy Now, after that jobs report which was fairly poor and the fourth poor one in a row, I joined with everyone else in seeing weakness in the market.
We still have five percent unemployment. The GDP is still growing at over 3% per annum, and the stock market continues to be trading near all time highs despite its recent weakness.
He has already cut rates by one full percent and soon we will have fiscal stimulus to go along with it. If they cut rates by another point along with the fiscal stimulus you could very well see too much inflationary pressure.
Any thoughts?
Was it over when the Germans bombed Pearl Harbor
Your argument is that the economy is strong and that financial markets are overreacting.
I'll leave that to the side and address your conclusion, which is that monetary policy should not be eased.
You make the standard counterargument, which is inflation.
Two responses to that: first, as I said in the original post, inflation expectations are nowhere to be found among bond investors.
Second, if you accept that the global economy is extremely strong, then I would argue that an increase in the money supply would find its way into investments in capacity to serve export markets, and also into foreign direct investment. Both of these outlets currently have very, very high expected returns.
If true, this means that monetary ease would result in growth, rather than inflation.
Great post as always. I found particularly prescient your last point about the inflationary impact of additional liquidity in a Democratic-induced drop in productivity.
I enjoy listening to Kudlow, but all Fall, in the face of the credit crisis, he seemed to stick his fingers in his ears and chant "Economy is strong--Goldilocks will continue." Both he and Art Laffer basically argued that the world economy was too big and too powerful to recede. Their eternal optimism eerily reminded me of the belief that the economy has (or that it even can) reached a permanent plateau that proved so foolish and damning 80 years ago. If I remember correctly, he previously argued that, while he thought the Fed would cut rates he didn't think they should. Thankfully, he has rescinded from this unrealistic "permanent plateauism" and is now discussing solutions.
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And statesmen at her council met
Who knew the seasons when to take
Occasion by the hand, and make
The bounds of freedom wider yet
- Tennyson, _To the Queen_
go down to 2002-3 levels, which is hell on retirees, who go yield chasing where they shouldn't, thus preparing the way for the next bubble.
And as the boomers are reaching retirement age, that next wave could be stronger than ever.