A CFG Symposium
On Tuesday, Ben Bernanke and the FOMC cut the Fed Funds rate by one-half percent. The stock market rallied on the news, with the Dow Index climbing over 400 point in one day. Clearly the short term effect was positive, but what does this rate cut mean for the long term health of the economy?
It's a controversial subject so I asked a handful of economists, whose opinions I deeply respect, to comment on the following question: "Was the 50bps cut a pro-growth or anti-growth move and why are others who disagree with you wrong?" Surprisingly, the answers are mixed.
Below are their responses.
BRIAN WESBURY
Housing is having trouble because monetary policy was too loose for too long, creating unsustainable incentives for investors to seek higher yields by taking on inordinate risk. Loose money is not an appropriate solution to problems caused by loose money.
The economy is strong. Real GDP ex-housing grew at a 3.1% annual rate in the first half of 2007 and looks like it's growing above that rate in the third quarter. The weakness in the labor market in August was due to a loss in government jobs and fewer teenage workers, the latter of which was due to an increase in the minimum wage. Monetary policy should not be used to offset government-imposed negative supply shocks.
Inflation is a threat. Although the CPI is up only 2% year-to-year, that is due to a big drop in energy prices in September/October 2006. In the past ten months the CPI is up at a 3.5% annual rate and that is where the year-to-year rate is headed over the next few months. Since the Monday close, the dollar has lost 1.5% of its value versus the euro, 2.5% versus gold, and 2% versus oil. Meanwhile, the inflation rate implied by the TIPS market for the five-year period starting five years from now is up 5-10 basis points since the rate cut.
It is no coincidence that the last two times the Fed cut rates in reaction to a sudden financial crisis - 1987 and 1998 - rates were higher about one year later and we started a recession 2½ to 3 years after the first "emergency" rate cut. In 1987, the Fed allowed inflation to creep higher, leading to nearly 10% interest rates by 1989. The 1998 rate cuts stoked the stock market and perceptions of higher inflation that led policymakers to raise rates way too high.
Cutting rates was unnecessary. More importantly, it increased the longer-term risks to economic growth from inflation and future Fed tightening.
Mr. Wesbury is chief economist for First Trust Portfolios, LP.
LARRY KUDLOW
Ben Bernanke's shock and awe, frontloading action to slash the fed funds rate 50 basis points from 5.25 percent to 4.75 percent (which I predicted, see Goldilocks 2.0) is just what the doctor ordered.
This is Mr. Bernanke's coming out party. It's his Fed now. In one fell swoop, Tuesday's move wiped Alan Greenspan off the front pages (thankfully).
Tuesday's Fed's action ultimately boosts financial confidence and reduces the cost of money. This in turn will help stabilize, even boost asset values across-the-board. It moves us away from the punitive inverted yield curve. It's pro-growth and it will increase the demand for money by reducing the interest cost of money.
Tight money had been strangling the low tax rate on capital and investment. So the Fed's easing move will revive the investment incentive effects from the supply-side tax cuts. The idea here is that the Fed had been squelching them and now is liberating them. Now the reduced interest tax on money has become more compatible and congenial with the low tax rate cost on capital.
The inflation hawks out there will be disappointed because stronger investment and growth will absorb liquidity and reduce the inflation rate.
Across the pond, the European Central Bank and the Bank of England may follow Bernanke's lead. They of course are suffering from the same problems we are.
I think this is ultimately bullish for stocks, bullish for the economy, bullish for the dollar, and bearish for gold. It will take some time for these things to work themselves out, but these are my expected outcomes.
Politically speaking, this sets up 2008 as a much better year for the GOP's bid to capture the White House. While the economy is in low gear, and will remain so for at least another six months, a brighter economic picture is in the cards.
Goldilocks 2.0 is not as good as Goldilocks 4.0, but bravo for Bernanke. I give him three cheers and a big thumb's up.
Mr. Kudlow is host of CNBC’s Kudlow & Company and author of the blog, Kudlow’s Money Politic$.
DONALD LUSKIN
The decision by the Federal Reserve to cut the fed funds rate by 50 bp this week is "pro-growth" in the sense that it will help alleviate the crisis of confidence in credit markets, and thus make it easier for businesses and individuals to borrow money in order to pursue their consumption and investment objectives. But it is naïve to think that the story ends there. The long-term effects of this action, and of the further future rate cuts that the market expects, will be to lower growth from what it otherwise might have been.
First, the crisis in credit markets is a direct result of the unwinding of speculative excesses that were set in motion in the first instance by the Fed's having kept interest rates so low for so long. In the long term, it would be wisest to let markets learn the lesson that risky lending has consequences, and that the Fed will not necessarily be there to bail-out speculators who guessed wrong. The Fed's move can be seen in that sense as a bail-out or subsidy, and as such as a government intervention with the same anti-growth consequences as any government intervention.
Second, by lowering interest rates, the Fed effectively increases the quantity of money liquidity in the financial system, and risks increasing inflation as a result. The reactions to the Fed's rate cut this week of surging gold and oil prices, and a dollar falling to all-time lows on forex markets, confirms that there are serious inflationary consequences in our future. Inflation is monetary crack - it promotes short-term euphoria, but in the end leads to ruin. Any short run growth effect will be more than offset by the dislocations and arbitrary transfers of wealth created by higher inflation, and ultimately by ruinously high interest rates that the Fed will eventually have to enforce in order to rein in the inflation it has created.
We have seen some commentary from economists who claim that lowering interest rates will stimulate growth sufficiently to offset the extra quantity of money created, thus neutralizing inflation risk. If that were true, then the Fed should set rates at zero, or even at negative numbers. Further, if that were true, then the predictions of those same economists that a rate cut would be greeted by falling gold prices and a rallying dollar would have come true. The very opposite occurred.
Mr. Luskin is chief investment officer of Trend Macrolytics LLC.
PAUL HOFFMEISTER
In real terms, the value of the nation's 500 largest companies appreciated 1.92% Tuesday in response to the 50 basis-point funds rate reduction. This is based on the facts that the S&P 500 increased 2.92% in nominal terms, while gold appreciated by approximately 1%. This real appreciation in the nation's capital stock suggests the FOMC made the right decision.
The Fed's manipulation of the fed funds rate is a highly ineffective policy lever. First, changes in the funds rate in recent years have not meaningfully changed the rate of money supply expansion. For example, in June 2004 when the funds rate stood at 1%, reserve bank credit was growing at an annual rate of 5.5%. As of last month, with the funds rate at 5.25%, it was growing at a 3.3% annual pace. A seemingly paltry difference given the dramatic increase in interest rates.
Most importantly, however, the manipulation of the funds rate lever by the FOMC ignores the demand for money, which is highly reactive to exogenous variables such as fiscal, regulatory and geopolitical events. The fact that money supply has expanded at a relatively consistent rate since 2004 while the dollar-gold price has sky-rocketed from $400 in June 2004 to more than $730 today suggest the demand for dollars in recent years has dramatically fallen.
If policymakers are stuck with only choosing which direction to push the cost of credit of the dollar-economy, the more appropriate choice is to lower it to reignite animal spirits, risk-taking and economic growth. An added bonus is: the lowering of the short-end of the yield curve should also alleviate the near freezing of the commercial and mortgage loan markets as lower interest rates resuscitate growth and invite bidders back into the market.
Over time if all major macro variables are held constant, renewed economic growth should absorb excess liquidity at the margin and improve the inflation environment, marked by a lower gold price.
Conversely, if the Fed did not lower interest rates Tuesday, or even worse chose to raise rates in the future, the distress in credit markets would likely further depress animal spirits, and could actually worsen the inflation environment as little or no new production at the margin absorbs excess dollar liquidity.
The most appropriate monetary response from the Federal Reserve, however, did not occur Tuesday. Instead of lowering interest rates, the global economy would have been better served if the FOMC announced it would target a specific dollar-gold price and allow interest rates to float freely. Ideally, the Fed should be selling bonds over time to sterilize enough excess dollar liquidity to cause gold to fall to $500, or even as low as $400; after which it would buy and sell bonds to maintain that price level. By doing so Fed technocrats would no longer be commissioned to guess the interplay between the supply and demand for money.
Mr. Hoffmeister is the chief economist at Bretton Woods Research.
MICHAEL DARDA
"By a continuous process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some. The process engages all of the hidden forces of economic law on the side of destruction, and does it in a manner that not one man in a million can diagnose." -- John Maynard Keynes 1920
With the Fed easing aggressively into cycle highs in oil and gold, and cycle lows in the dollar, the ghost of Arthur Burns has sprung back to life. While easy money always feels good in the beginning, in this environment it amounts to nothing more than giving an alcoholic another beer in the hopes that his hangover will be less severe. Those arguing aggressively for a rate cut(s) did so with the caveat that the Fed could always take it back if it happened to be a mistake. It will be the take-back -- to levels that will be higher and in place longer -- that will make the hangover from this additional bout of easy money costly and ultimately painful.
It's not all bad news, of course. With the yield curve steepening aggressively, credit conditions easing (commercial paper and Libor rates have collapsed in the wake of the Fed's move), and financial markets melting up, there is little doubt that the economy will pick up steam in 2008. This inflationary fillip to growth may even be viewed by some as worth it if it helps Republicans in the 2008 Presidential elections. But this is a myopic view: when economic "steam" is generated by liquidity (i.e., "demand"), it will carry with it higher inflation as well. The Fed can create money, but it can't create the goods and services to spend it on. Why this lesson has failed to be learned over the decades seems nothing less than mystifying.
In short, I fear that we are moving toward an environment characterized by rising tax rates and loose money. In the long term, this will raise prices and restrain growth -- precisely the opposite of the original supply-side policy mix that saved the world from inflation, stagnation and totalitarian domination.
Mr. Darda is the chief economist and director of research for MKM Partners.
