Dr. P.V. Viswanath
By BRIAN S. WESBURY
The stock, bond, currency and commodity markets are bouncing around wildly. While there are many crosscurrents, monetary policy and economic data are front and center in day-to-day market volatility. As a result, some market observers are trash-talking the new Federal Reserve Board chairman, Ben Bernanke, and blaming him for all sorts of perceived missteps.
This is unfair. Mr. Bernanke is doing a fine job. The inflationary pressures he is fighting today were baked in the cake before he arrived. Monetary policy was overly accommodative for too long, and even after 16 rate hikes the Fed has not yet reached neutral. Weaning investors, home builders, hedge funds and proprietary trading desks from 50-year low interest rates is like forcing them to quit smoking: It's good for the health of the economy, but it hurts and they are complaining loudly.
There are two forces that cause the economy to grow. One is real, the other is an illusion. The real force -- entrepreneurial innovation and creativity -- comes naturally as long as government policies do not drive it away. The artificial force is easy money. An increased supply of money, by creating an illusion of wealth, can increase spending in the short run, but this eventually turns into inflation. Printing money cannot possibly create wealth; if it could, counterfeiting would be legal.
For monetary policy makers and investors it is important to determine to what extent growth is due to each force. In the late 1990s, when the economy and equity markets were booming, the Greenspan Fed became convinced that monetary policy was largely responsible. But commodity prices were falling and the dollar was strong -- both signs that Fed policy was not the culprit. The Fed hiked interest rates anyway. This was a mistake. The U.S. economy fell into recession and deflation became the No. 1 fear of financial markets and central banks around the world.
The Fed fought this deflation -- by cutting rates 11 times in 2001 -- eventually pushing the federal funds rate down to 1%. In late 2001, commodity prices began to rise, and in early 2002 the dollar began to fall. But because it was so worried about deflation, the Fed ignored these signs of monetary excess and held rates artificially low well into 2004. This policy has finally come home to roost.
Inflation is on the rise. "Core" consumer prices have climbed 3.2% at an annual rate in the past three months, the fastest growth since 1995. Mr. Bernanke said recently that inflation has "reached a level that, if sustained, would be at or above the upper end of the range that many economists, including myself, would consider consistent with price stability and the promotion of maximum long-run growth."
What the market is debating is whether fighting this inflation will hurt the economy. With housing activity down sharply, these fears are palpable. But this is likely an overreaction. Housing was stimulated to extraordinary heights by artificially low interest rates (and the 1997 capital gains tax cut) and is now correcting back to more normal levels. Housing starts may be down 18.4% from their peak, but they are still up 12.3% from 1999 levels. It may be painful for participants in the construction industry and those who thought they could make a fast buck flipping houses, but only a recession could send the housing market into a tailspin.
Historically, housing has been a solid leading indicator of business cycles, but the special circumstances of recent years suggest that this time it is sending a misleading signal. And while some believe that a slowdown in housing will undermine consumer spending, this fear is overblown. Cash-out financing (or mortgage equity withdrawal) may have increased spending for those who took advantage of low interest rates to refinance, but every dollar of borrowing was funded with someone else's savings.
With interest rates up and refinance activity down, the savings do not disappear, but instead are used in different ways. Resources that would have been put into housing will be shifted to other sectors of the economy. One area that appears to be benefiting already is business fixed investment. Commercial and industrial loans are up 14.9% at an annual rate during the first four months of this year, and after five years of sluggishness are finally growing at rates similar to those of the late 1990s.
In other words, there is little evidence that rates have reached a level that is detrimental to the economy. The Fed is not tight; it is just less loose. This can be seen in real time by watching market-based indicators. Commodity prices remain elevated and the dollar continues to weaken; both suggest excess money creation. Moreover, the economy has not experienced a recession in over 45 years without the federal funds rate rising above nominal GDP growth. In the past year nominal GDP growth has been 6.9%, so with the federal funds rate at 5%, monetary policy is still accommodative.
Nonetheless, the Fed is very close to a neutral monetary policy. Using nominal GDP as a target, and looking back historically, a neutral rate is likely close to 6%. If the Fed could get rates to this level soon, the economy could continue to grow based on underlying entrepreneurial activity and productivity -- a rate estimated to be 3.5% or 4% per year. A neutral rate would also put a lid on inflation, stabilize the dollar and cap commodity prices, including oil. A 6% federal funds rate would be monetary policy nirvana.
Now that the Fed is close, the future path of short-term interest rates has become less certain. After two predictable years, with a rate hike every six to eight weeks, a great deal of leverage was employed by investors who understood the pattern. Lately, many investors have been betting on an early end to rate hikes, but with Mr. Bernanke remaining vigilant about inflation this leverage has become more risky. The result is volatility. In retrospect, if the Fed had moved rates up faster than it did, it might have been able to stop sooner. Unfortunately, the longer the Fed maintains an accommodative policy stance, the higher the neutral rate becomes.
The good news is that there is no reason to suspect that this volatility is anything more than a short-term phenomenon. During the past two years, the Fed was trying to wean the economy from low rates slowly, so as not to shock the system. But in doing so, it allowed inflationary pressures to accumulate. Ben Bernanke is finishing the job and cleaning up the mess. While this may create some near-term turbulence in financial markets, getting rates to neutral will be a huge benefit to the economy.