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 significant stimulus. 

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 think not. 

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 percent. 

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. 


mbar.jpg (9380 bytes)