June 25 , 2003
As the Federal Reserve is about to begin a two day meeting
on the economy that probably will culminate on Wednesday June 25 with yet
another reduction in their targeted overnight bank rates, I thought I would
provide a brief summary of what I would be saying if I were there.
First, there already is a lot of economic stimulus being
pumped into the economy. Previous
tax cuts have not yet used up all their stimulus medicine.
The latest tax reduction removes some timing problems that prevailed when
child tax credits, marriage penalties and reduced marginal tax rates were
scheduled for future reductions. Making
them effective this year and changing the July withholding tables will provide
Second, the dollar's weakness has removed some impediments
to export growth. At present
currency rates, American producers have a fair chance to gain sales abroad.
Yet, productive international producers still have incentives to increase
their international sales. Relative
to domestic costs, currencies outside China probably are the nearest to desired
levels in several years.
Third, despite the dollar's more appropriate valuation, not
enough stimulus and economic reform is occurring in many world markets.
The recent shift toward expansive monetary policies in Europe is only a
first step toward more needed stimulus in that part of the world.
Japan needs more bank reform (possibly allowing
international mergers of their major banks to inject much needed lending
capacity into their economy). Pension
reforms and the removal of inflation indexed devices that no longer are needed
must be accelerated in some of the Latin American economies.
In short, the global recovery is not yet assured.
Fourth, near term energy uncertainties still could derail
expansion. Iraqi oil has been
slower to reach world markets than anyone expected.
Fortunately, a cool spring has allowed North America to partially rebuild
inventories, but Europe has not been so fortunate.
The longer term outlook remains favorable for energy, but weather induced
price spikes are possible through next year.
Fifth, despite assertions that short term rates could fall
to zero, such a low rate would create serious problems for liquid assets, such
as interest bearing checking accounts, short term certificates of deposit and
money market rates. The ability to
market and administer such instruments might require fees, with unintended
consequences on liquidity holdings.
A quarter point reduction in overnight rates would not
create problems. Indeed, such a
reduction is so widely anticipated that failure to make such a move would
unsettle financial markets. A half
point reduction may be absorbed without problems, but anything larger would
create distortions. Therefore, the
effective remaining ammunition in rate reductions is half a point.
To use up all this ammunition before the global and energy
uncertainties are resolved would leave the Fed with few traditional methods to
deal with further weakness.
Is the danger so great that all that available ammunition
should be used at this time? I
While manufacturing clearly is suffering from continued
declines in unit costs from abroad, especially China, economy wide deflation has
not occurred. In the past year,
consumer prices have increased 2.1 percent.
Excluding the direct impact of food and energy, the increase has been 1.6
To be sure, consumer prices are unchanged in the past three
months, but that is because of falling energy prices. A concurrent dip to 1 percent in the core inflation rate also
should be viewed without serious concern. Falling
energy prices indirectly impact transportation service, lodging service, and
rental costs. In these areas energy
is not effectively removed from the
core inflation rate. Thus, falling
energy prices push down the core while rising energy prices hold it up.
If these indirect effects of energy are removed, the core inflation rate has been relatively stable at slightly more than 1.25 percent in the past year. This is desired price stability, not undesirable deflation.
Thus, hold that extra quarter percent powder in case global
and energy uncertainties turn into more serious issues.
Believe in economic theory.
The previous monetary expansion, current tax cuts, and a
more appropriately aligned dollar should begin to stimulate this economy.
Uncertainty has been the reason that it has not done so thus far.
As those uncertainties diminish, and they are doing just
that, the strength of the stimulus medicine will begin to take over.
Nothing is certain. A new terrorist attack would be damaging. Further oil disruptions in Nigeria, Venezuela, Iraq or elsewhere could be disruptive. So keep some ammunition and only cut by the quarter point that already has been virtually promised to the marketplace.