The New Productivity Paradox and Fed Monetary Activism. The full report, titled “Impatience at the Federal Reserve” can be downloaded in your favorite flavor:
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Of the past 13 eases, today’s is the most difficult to justify, at least on a purely economic basis. Since the war in Iraq ended, consumer confidence has rebounded, retailing has improved and oil prices have come down. The Wall Street Journal noted that “Corporate bond issuance is booming, and mortgage-refinancing applications exceed the capacity available to handle them. Total commercial bank assets have climbed by 11% in the past year and bank profits have soared – a clear sign that the financial system is not starved of liquidity . . . Purchasing managers’ indices are rising, deal-flow is improving again on Wall Street, corporate bond spreads have narrowed sharply, and the stock market is up.”
Our curiosity has gotten the better of us: What is it that is motivating the Fed? The Fed’s impatience is an enigma. Unless the system receives another external shock (i.e., war or terrorist attack), it’s reasonable to expect a slow but continuing recovery. Indeed, the possibility of a “shock event” is itself reason to keep some powder dry, just to be able to determinedly respond if such an untoward episode were to occur. This makes today’s cut all the more intriguing.
The New Monetary Activism
Its hard to call a 13th rate cut “new;” Its only within the framework of the present environment that what was once a gradualist form of intervention has morphed into something much more radical. The Fed has subtly changed from being “social rate cutters” into “problem interventionists.” I suspect they are thinking: “We can stop anytime we want . . .”
The weak but improving economy certainly doesn’t demand further cuts. Its not as if there’s been a “ground swell of complaints about high interest rates or tight money,” observed the Wall Street Journal. The American Enterprise Institute similarly noted that “GDP growth will rise to 4 percent and probably overshoot to 5 percent for one or two quarters in 2004, in a long-awaited, normal cyclical recovery pattern, on the way to sustainable growth of 3.5 to 4 percent.” With the economy on the mend, GDP should start creating jobs over the next 24 months. Today’s 1/4 point cut reveals more about the Fed’s impatience than it does about the state of the economy.
Nor does the recent Fed jawboning about deflation ring true. Some strategists have taken to referring to the specter of falling prices as “the deflation ghost.” None other than former Federal Reserve Chairman Paul Volcker addressed the subject earlier this week. Speaking Monday at a forum on the state of the global economy at the London School of Economics, Volcker commented “If I were setting odds on deflation in the U.S., the probability wouldn’t reach 0.1 percent. I see no prospect of real deflation like we had in the U.S. and other countries in the 1930s.” The widely respected Volcker’s comments effectively repudiated deflation as a factor in making further rate cuts . . .
The Fed’s role
Apparently, the Fed’s role has changed from “cushioning the pain in a downturn, towards creating a new expansion cycle.” This is a radical change.
The new objectives of monetary policy, as well as the methodologies employed, reflect a newly radicalized Fed: “This policy cycle can arguably be seen as revealing a more powerful and preemptive use of fiscal and monetary stimulus than any prior post-World War II cycle,” observed Michael Englund, chief economist for MMS International Analysts. In a recent Business Week article, Englund further added, “much of the economic stimulus in the pipeline is only now taking effect, as yields on longer-dated securities have just recently pulled back a significant degree, and a big portion of the combined tax cuts of the last three years is expected to kick in during June and July. All this is occurring while “real” interest rates (as adjusted for inflation) have fallen from cyclically firm levels to historic lows that now reflect extraordinarily depressed nominal levels overall.”
Indeed, this radically new monetary activism – and its broad intervention in the markets – is now in uncharted waters. “We have an amount of stimulus beyond anything I’ve heard of in history” were the not so subtle observations of former Fed Chief Paul Volcker.
Relationship between the Productivity Paradox and Monetary Activism
The economy has reached the point in the cyclical recovery where the Fed’s considerable economic stimulus is finally having an impact. All manners of economic activity have shown a modest rebound. And, much of the stimulus is still “in the pipeline.”
The biggest laggard remains employment – historically, the last data point to see a rise in any economic recovery. As the excesses of the bubble get worked off, employment should see a gradual improvement. But this development will be a function of time, not monetary policy. Indeed, some have argued that the extremely cheap cost of capital allows companies to “hang around,” instead of weakening to the point where the normal consolidation processes can occur.
The combination of this excess capacity and increased productivity suggests that employment will continue to lag the broader recovery, only gradually rising when GDP growth finally tops 3.25%. Barring unforeseen circumstances, that’s not likely to occur until later this year at the earliest, and more likely sometime in 2004. But it should happen eventually.
Hence, the Fed’s impatience and monetary activism appears to be unusually tied to the calendar. Unwilling to allow their already substantial stimulus to gradually work its way into the system, the Fed has opted to engage on a surprisingly activist agenda.
The most obvious event in 2004 possibly motivating the Fed’s latest intervention is the Presidential election.
The Dangers of Excessive Intervention
The Fed’s impatience and their surprisingly activist stance raise several danger signals: Aggressive market interventionism is invariably accompanied by unintended consequences. We suspect that – eventually – the result of the Fed’s impatience will be felt long after the present Fed Chief has retired
In the 1960s, then Federal Reserve Board Chairman William McChesney Martin made the famous quip that it was the Fed’s job “to take away the punch bowl just when the party is getting going.” Alan Greenspan tends the economic bar differently: He is freely offering drinks to the already inebriated; We should not be surprised by the consequences.
