August 23, 2001


As analysts continue to fall over themselves in revising downward their earnings estimates for the second half of this year, they are asking one major question: Where is the second half rebound that monetary and tax policy should have launched?

Not surprisingly, many are saying this is a "new" environment. Monetary policy no longer is potent and tax reductions are being saved. Indeed, policy no longer matters according to this reasoning.

Of course, we heard about "new" environments two years ago, when the expansion was supposed to be immune to cyclical pressures. Yet, with world influences becoming more prominent, can local economic policy really make that much difference.

I certainly believe that coordinated world policy is better than individual efforts. Everyone would be better off if the European Central Bank were fighting stagnation just as the Japanese and American central banks are trying to do. The boat moves faster if everyone is stroking to the same beat.

Having said that, let us examine how impotent American policy is.

Seven interest rate reductions have not turned around this economy. Those latest initial unemployment claims suggest that employment growth remains nil. With capital being utilized at only 77 percent of capacity, even very low interest rates are not about to open the order books for equipment.

Most significantly, stock values now are about 5 percent lower today than they were when interest rates began falling on January 3. If declining interest rates could do nothing else, they should have raised the current value of future earnings.

Before declaring that this means monetary policy cannot do the job, let us see where monetary policy was when interest rates began to tumble.

At 6.5 percent, short term interest rates were more than 3 percentage points above inflation (now running 2.7 percent for the past twelve months). The Fed was on the brakes. The first two moves merely took away monetary restraint. Only the last couple of cuts have propelled rates low enough relative to inflation to suggest that monetary policy is now pressing on the gas pedal.

Thus, earnings estimates were delayed in getting to realistic levels because analysts failed to recognize that the Federal Reserve initially was merely reducing the level of restraint. Only now are the earnings estimates (and presumably the stock values) approaching realistic levels.

However, even with such belated policy shifts, the economy has benefited. Housing activity has remained surprisingly robust. Without Federal Reserve interest rate reductions, housing would be hundreds of thousands of units lower than it is today.

Even durable goods purchases have been surprisingly robust for the earnings and employment gains registered by households. Nearly zero interest rates will sell cars, even if not as many as when more people were employed.

By early next year, the movement to monetary stimulus will have lowered the value of the dollar (another sign that monetary policy really did not move to stimulus until recently) and supported stronger values for stocks. Employment gains will follow and, with a lag, so will capital spending.

Unfortunately, the tax rebate was sold incorrectly. Those checks are payment for the first year of a new 10 percent tax bracket. They are not one time rebates, as too many analysts have suggested.

Most households will pay down debt when they receive one time tax rebates. They will increase spending when they get a permanent reduction in tax liabilities. Sometime in 2002, households may discover that they have lower tax liabilities. Then they will spend.

In other words, a misunderstanding of policy rather than an absence of policy potency is responsible for the current failure to respond to policy changes. As understanding improves, so will the potency of those policies.

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