End the Rate Increases

[adios]

An interesting take on current monetary policy. I think it's fair to say that the bond market views inflation risks as declining.

End the Rate Increases

By JOHN MAKIN
October 19, 2004; Page A18

The U.S. economy is heading for a post-stimulus hangover. The double drag from higher oil prices (a tax increase) and higher short-term interest rates is not helping. If we aren't careful, we'll have a recession in 2005. That possibility makes even more dangerous the tax increases being proposed by John Kerry.

Don't get me wrong. The economy has had plenty of help, at least up until this fall. Two rounds of Bush administration tax cuts added about a percentage point to growth for most of the period since mid-2001. First, by helping to end the brief recession that ran from March to November 2001, and then helping to sustain growth in 2003 and early 2004. The Fed did its part, cutting the federal-funds rate in half from 3.50 to 1.75 during the first two months after the Sept. 11 shock, and then cutting by another 75 basis points during the 2003 deflation scare.

With all of this well-executed stimulus from monetary and fiscal policy, the U.S. economy has averaged 3.5% growth since the end of 2001, even with an extraordinary negative real fed-funds rate averaging -0.5%, the lowest level in a period of falling inflation since the great depression of the 1930s. Achieving only trend growth required tax cuts and a negative real fed-funds rates that generated record low mortgage rates and cash out refinancings worth $100 billion annually. Also, oil prices stayed down until the second half of 2003.

If with all that stimulus and low oil prices, we managed just 3.5% growth, how can we manage the 5% growth the Fed predicted last July as it started raising the federal-funds rate? Indeed, now that the fed-funds rate is up to 1.75%, tax cuts are over, "refis" are down, and oil prices are up $25 a barrel since the second half of 2003, how can we be sure we don't have a recession coming in 2005?

Most models suggest that higher oil prices cut growth with a lag of six months or more, notwithstanding Alan Greenspan's claim to the contrary. We probably haven't yet seen the negative growth impact of the $25-a-barrel rise in oil since the second half of 2003 and that will be, conservatively, at least 1 percentage point off of trend growth. Take away another 1.5 percentage points from the expiration of fiscal stimulus and cash out refinancings and add in some more drag from higher short-term interest rates and you are close to zero growth. A lower stock market tied to earnings disappointments could do more harm. Falling long-term rates are presently a symptom of slowing growth.

Higher oil prices are acting like a tax on households and producers and so are penalizing growth while not raising inflation. That's the message emanating from lower long-term interest rates world-wide. Both aggregate supply and demand curves are shifting leftward. Higher oil prices mean less output at each price level, a negative supply shift. Higher oil prices, lower cash-out refinancings and an end to tax cuts subtract from demand growth. Real consumption was flat in August. While it may rise in September given a dumping of auto inventories, and a late Labor Day, the sharp drop in October consumer confidence to its lowest level since the deflation scare in April 2003 bodes ill for consumption going forward. Meanwhile, inventory growth, begun during the second quarter, has continued, signaling a need for a production slowdown that has begun. Industrial production in the three months ending in September rose at an annual rate of just 2.8%, down sharply from the previous year's 4.7% growth.

Weak demand growth and some inventory buildup have erased last spring's inflation scare when core inflation measures moved toward 2% and were expected to move still higher. Core CPI inflation was only 1% annualized during the three months ending in August, down from a 2.2% rate for the previous six-month period. If the Fed was thinking of a 2.5% inflation rate by year-end when it began tightening in June, it may have thought that a fed-funds rate at that level, yielding a zero real fed-funds rate, would still be accommodative. The minutes of the Fed's August meeting, when the fed-funds rate was raised to 1.5%, suggested this view: "Given the current quite low level of short-term rates, especially when judged against the recent level of inflation, members noted that significant cumulative policy tightening would be needed. . . ."

The drop in inflation to 1% would mean that the real fed-funds rate has already risen to 0.75%, still low, but in the context of the past several years, still possibly too high to support trend growth, especially given the withdrawal of other stimulus coupled with a substantial oil tax.
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Going forward, sustaining growth will require three key steps. Although the leeway for further tax cuts is limited, current tax cuts should be made permanent in order to give households and firms greater confidence about the future tax environment while avoiding additional tax burdens to the substantial drags already hitting the economy from higher energy prices. Beyond that, marginal tax rates should be further reduced with revenue losses recouped by eliminating tax preferences.

Second, the Fed needs to sharply re-examine its concept of the current neutral real fed-funds rate. The evidence of the past several years suggests that the neutral real fed-funds rate for the post-equity-bubble U.S. has been closer to 0% than 2%, so any increases in the fed-funds rate above current levels should be undertaken only after careful examination of an appropriate rate. The rationale sometimes heard, that the Fed needs to raise the fed-funds rate in order to have the leeway to cut it in the future, is essentially silly if such rate increases themselves lead only to the need for future rate cuts.

Finally, whatever the growth environment, the U.S. needs to reassert its leadership in the trade arena and avoid restrictive trade practices both at home and abroad with renewed vigor.

The only one of these three steps that can be undertaken quickly is an end to rate increases by the Fed until the pace of growth becomes clear in coming months. With inflation and growth both falling, there is no inflation risk attached to a pause in Fed rate increases. We don't need a recession to tame inflation -- the usual rationale -- and we certainly don't need a recession that reignites deflation risks.

Mr. Makin, resident scholar at the American Enterprise Institute, is a principal at Caxton.