Jewish World Review August 22, 2001/3 Elul 5761
http://www.jewishworldreview.com -- MARKETS are smarter than Phillips curves or frequently-revised GDP numbers. So on the eve of the August FOMC meeting, commodity and financial indicators are still signaling an inadequate volume of high-powered liquidity in the economy. Inadequate, that is, to finance all but the most tepid sub-par economic recovery.
One clear sign of a liquidity shortage is today's drop in gold and the CRB futures breakdown below 200. Gold in particular had mounted a modest rally, presumably anticipating a 50-basis point Fed cut in its target rate. But this expectation may have been smothered by today's leading indicators advance, which was falsely driven by a push in M2 growth.
A more powerful sign of the need for a 50 or even a 75-basis point move by the Fed can be found in the short end, or liquidity end of the Treasury yield curve. At 3.70% the two-year Treasury note is trading slightly below the 3.75% fed funds rate. This is not good.
A more normal liquidity spread would have the Fed's policy rate about 75-basis points below the two-year note. This would allow banks an easy two-year carry trade that would profitably enhance their earnings and capital lending base for renewed credit expansion. As the U.S. economy came out of the last recession in the early 1990s, the two-year note traded at least three-quarters of a percentage point above the funds rate.
Here's another point on the 2-year note. Right now the inflation expectations spread between ten-year Treasuries and their inflation-indexed counterpart has fallen to 150 basis points. Subtracting that from a 3.75% fed funds rate leaves a 225 basis points real fed funds rate. This is way too high.
Interestingly, the TIPS spread is about in line with the consumer price index over the past three months and the core personal spending deflator. Using that core PCE deflator as a benchmark, during the 1993 early recovery period the so-called real fed funds rate was about zero.
So if the monetary authorities were to apply early 1990s-type stimulus to today's situation, they could easily cut the overnight target rate by 75 basis points to 3%.
Will they get there? Well, the fed funds futures market says no, showing a 100% probability of a 25-basis point cut in August, with only a 12% chance of a half-point reduction. In the fourth quarter, the futures market is signaling an 84% chance of one additional 25-basis point cut, which would place the funds rate at 31/4%.
Since the last funds rate reduction in June, U.S. stocks and the economy have been sagging. The central bank appeared to be sleeping in their ignorance of worldwide deflationary pressures that ultimately can only be cured by U.S. monetary leadership.
As today's lead story in the New York Times correctly noted, the entire world economy is faltering to an unexpected degree. Wall Street Journal editor Robert Bartley has come round to the Fed-must-do-more viewpoint in his column today, citing Nobelist supply-side guru Robert Mundell as a key source.
"We're not out of the woods yet," Alan Greenspan told Congress about a month ago. The same is surely the case today, a month later. In the U.S., for example, recent economic reports show that business sales are falling faster than inventories, consumer spending continues to slow, carmakers are announcing layoffs, computer-makers are still gloomy and foreign trade is sagging. Also, a tightening of OPEC production is keeping oil prices at least 25% higher than they need to be.
On the brighter side, monetary base growth (the Fed's basic liquidity measure) has picked up and producer profit margins have in most sectors turned positive for the first time in two years. So, yes, there is some light at the end of the tunnel.
But the Larry Lindsey mantra that a consumer-led recovery is just around the corner is still a bit too much Papa Bush-esque for my taste. And Paul O'Neill's rejection of a capital gains tax-cut or other business tax relief measures that would directly impact the recessionary business investment sector is the wrong policy signal. Democratic arguments that budget surpluses should be maintained in recession are totally Hoover-esque. An honest Keynesian would adopt the supply-side model right now. But economic honesty is in short supply in Washington.
I'm pulling for a 50-basis point surprise from the Fed tomorrow. There's still a chance that the G-3 central banks are coordinating a bigger dose of global monetary stimulus than most observers think, an argument put forward by Bill Kucewicz last week. That would re-ignite stock market spirits and trigger a global rally even while world economies languish. Keep hope alive.
More to be
JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.