Waiting for Greenspan

Next week, the Federal Reserve Open Market Committee will meet to revise monetary policy targets, including the inter-bank lending, or fed funds rate. The fed funds rate is the interest rate one bank must pay another to borrow money to meet its reserve requirement ratio, which itself is set by the Fed. Recent economic news suggests that the economy may be heading into another recession as business investment continues to fall, consumer confidence reaches 10-year lows, finished product prices fall, and the stock market fails to sustain momentum. Currently stuck at an over 40-year low of 1.75 percent, the fed funds rate may be cut further, as many policy analysts suggest is necessary to cope with the threat of deflation and continued economic stagnation.

While no one can dispute the importance of Federal Reserve policy to the nation and world macroeconomy, the fed funds target – the only reliable tool the Greenspan Fed employs to bias lending decisions – is inexorably influenced by treasury yields (definition) because banks can choose to lend their excess reserves to other banks at the fed funds rate, or to the government by purchasing bonds. Since 1994, the Federal Reserve has made public the fed funds target rate following its Open Market Committee meetings.

When the yield on short-term treasury bonds dips below the fed funds rate, as it has for three-month, six-month, and 2-year notes, the market is betting on another cut in the fed funds target rate. And when this happens, the Fed is almost obliged to purchase treasury bonds to add liquidity to the banking system and bring fed funds rate into alignment with short-term yields. If it fails to do so, the inter-bank lending market would operate less efficiently as banks substitute short-term debt for the fed funds market (or vice versa) depending on their reserve positions.

Moreover, as Fed economists Vance Roley and Gordon Sellon argue, market expectations of Fed policy decisions affect the behavior of interest rates in a similar way to the policy decisions themselves, meaning the Fed is not a market maker, just its most important actor. Evidence to suggest that a cut in the Fed funds target is already priced into asset markets, exchange rates, and treasury yields means that the actual policy action will not do as much to buoy the economy as many suspect.

That is unfortunate news given the nation’s current fiscal policy bias. Instead of hastening implementation of the Bush tax cuts and making them permanent, Congress has favored policies to provide a short-term boost to aggregate demand. Government spending is up $154 billion this year alone, including an $84 billion spike in discretionary spending. In addition to this substantial increase, many lawmakers support payroll tax cuts, targeted income tax rebates, or other transfers to constituencies less likely to save. But since the already enormous injection of government spending has done little, if anything, to bolster growth why would Congress pursue other Keynesian “pump-priming” measures just as likely to fail?

What troubles the economy is not a lack of government spending or aggregate demand, but sagging corporate profits that have led to round after round of cost cutting, which has manifested itself in continued unemployment and September’s 12.6 percent drop in capital goods spending, the biggest such drop in over 5 years. While the Sarbanes-Oxley regulations on corporate accounting and governance were designed to improve transparency, they also have limited the flexibility of corporations to cope with the downturn and have increased compliance costs and legal risk, all of which have further depressed the economic outlook.

Low interest rates have made it easier for corporations to service the debt accumulated during the late 1990s, but the decline in the core Producer Price Index (PPI) of 0.4 percent over the past 12 months has more than offset the cheaper financing. When the PPI falls, businesses lack pricing power, which reduces their revenue per unit sold, making it more difficult to pay off loans. In this mild deflationary climate, business investment will remain stagnant irrespective of the fed funds rate. As long as cost cutting remains the only viable strategy corporate managers can undertake to improve prospects for shareholders, mild deflation and slow growth will persist.

Congress has many tools at its disposal to affect corporate decision-making in substantive ways. Cutting the top corporate tax rate to 30 percent, while allowing businesses to expense capital purchases in their entirety could prevent further erosion in business investment by making expansion projects in sectors not affected by chronic overcapacity more affordable.

Enacting all of the Bush tax cuts in their entirety by 2003 would ease the stress on per-unit labor costs that has limited disposable income growth and provide unexpected liquidity to the segment of the labor force more likely to bear risks. Making them permanent would eliminate the significant dead weight costs associated with legal uncertainty and keep more future income in the private sector, which will improve long-term economic forecasts and bolster asset prices today.

Of course the Keynesians who pursue clandestine “pump-priming” through government spending increases will say that the nation can’t afford tax cuts and that the resulting budget deficit will increase interest rates. Not only, as Chicago Fed economists Charles Evans and David Marshall found last year, is there scant evidence to suggest that a fiscal policy shock affects interest rates, when the demand for new loanable funds is as low as it is now, it is difficult to see how a budget deficit of the size contemplated could crowd-out private investment, or drive up interest rates.

Budget deficits are theoretically capable of driving up interest rates in closed economies with limited supplies of loanable funds, but it borders on disingenuous to suggest that deficits will increase consumer and business financing costs in a sluggish world economy suffering from mild deflation in its largest economy, prolonged stagnation and deflation in its second largest, and incipient deflation and recession in its third largest.

It’s time for Congress to step out from the Fed’s shadow and take some responsibility for the economic outlook by passing a package of pro-growth tax cuts.