Why the Fed Is Right to Inject the Economy With More Dollars
Suddenly, nearly everyone wants the Federal Reserve Board to cut interest rates. I’ve been arguing for this for nine months, so it’s nice to see the economic intelligentsia is finally persuaded. The Fed has become a restraint on growth since last August thanks to ill-advised interest rate increases (and promises to raise rates more in 2019), which slowly squeezed out of the economy dollar liquidity and tanked the stock market.
Fed Chairman Jerome Powell is finally signaling a rate cut by 0.25 of a percentage point next week. This almost certainly will be accompanied by a reduction in the interest rate the Fed pays banks on reserves. That policy has reduced bank lending and shrunk the money pool as well. The stock market has reacted bullishly in anticipation of this decision to inject the economy with more dollars. The Fed’s primary job should be price stability with minimal inflation, but for many months now, inflation has fallen below its standard target.
What is bewildering is that so much of the analysis for why the Fed should cut rates is upside-down. The New York Times editorial board and others argue that a slowing economy demands easier money. But that’s outmoded Keynesian illogic based on the belief that money causes growth. It doesn’t. In the 1970s, the Fed tried to juice growth with inflationary money injections; we got less growth and more inflation. But excessively tight money can choke growth, too.
The reality of the Trump economy is a lot different than the easy-money crowd thinks. Yes, it’s true that the trade war and global economic sluggishness has slowed domestic growth here at home. The U.S. growth rate surged to more than 3.5% last summer with no signs of inflation to be found. Now, we are at closer to 2% to 2.5% growth, and some of that is due to excessively tight money.
There are all sorts of market signals of tight money. Commodity prices are still 5% to 10% below where they were this time last year. The consumer price levels have been close to 1.5% — which is below the Fed’s target. I don’t want inflation, but the bigger threat right now in some markets is deflation.
There are many other warnings of tight money. Nominal GDP has contracted from last year. And consider the change in market indicators today versus last August, before the two rate hikes happened. Last year, the interest rate on the 10-year Treasury was 3.1%. Now, it is closer to 2%. This is a sign of declining inflation expectations. Even more amazing is that the five-year Treasury Inflation Protection Securities spread, which is one of the best forward-looking measures of inflation, has fallen from 2% to 1.6% over the last year. This means the market is betting on inflation of well below where the Fed wants it. Time for dollar liquidity.
Trump is battling a culture of limits to growth at the Fed. The president is correctly shooting for 3% to 4% noninflationary growth in the economy (as was laid out in the economic plan we put together back in the 2016 campaign), but most economists at the Fed and in academia believe this is an impossible dream. They think 3.5% real growth — stoked by tax cuts, deregulation and domestic energy production — will only accelerate inflationary impulses. Wages under this model have to be kept under wraps to avoid wage-push inflation.
No. Policy changes that promote the production of goods and services don’t cause inflation. If anything, more output leads to lower prices. That happened in the Reagan years, when the economy boomed and inflation fell from 12% to 3%. Ronald Reagan proved high growth and stable prices can peacefully coexist. This happened in the Clinton years as well, when federal spending was cut dramatically.
Of course, the Fed should always keep a watchful eye on inflation, and if it rears its ugly head, the rate cuts and other liquidity measures should cease. But the limits to growth skeptics are wrong. This Trump economy has the capacity to grow north of 3% for years to come. Sorry, Elizabeth Warren, there is no recession or financial crisis around the corner unless the Fed mistakes like last year steer us over that cliff.
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