Over the last three years, tax cuts and Federal Reserve interest rate cuts have failed to produce sustained strong growth of the American economy. Now, however, powerful demand stimulus from three sources--tax cuts, a weaker dollar, and an important new phase of monetary policy aimed at preempting deflation--is operating simultaneously to boost demand growth. The result will be the absorption of excess capacity over the coming year, followed by a recovery of investment spending and then employment growth. As this process unfolds, 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.

Greenspan Is Right about Deflation

Federal Reserve chairman Alan Greenspan is right to raise concerns about deflation before it occurs. By moving aggressively with help from Fed governor Ben Bernanke to counter the possibility of deflation, he has helped to ensure a return to sustained 4 percent growth by early 2004. The preemptive response--more Fed rate cuts this summer coupled with strong indications that short-term rates can stay low for an extended period--is analogous to a doctor prudently treating a respiratory infection: administer a large dose of penicillin before the patient develops serious pneumonia. If the large dosage is unnecessary, no harm done. If, on the other hand, pneumonia, or in the case of monetary policy and the economy, prolonged slow growth, is averted, a good deal of unnecessary pain and suffering does not occur.

In the new phase of preemptive monetary stimulus being engineered by the Federal Reserve, targeting a stable price level is crucial. The addition of avoiding deflation to the Fed's mission of avoiding inflation is tantamount to targeting a stable price level, since it implies an active Fed response to the prospect of either a falling or a rising price level. Furthermore, inflation targeting, at 1 to 2 percent, is the equivalent of targeting price stability in a world where measurement error tends to bias measures of inflation upward. The Fed's step leveling this direction is immensely significant as it satisfies a necessary condition to avoid deflation. Moving from a backward looking concern about inflation, with its implied threat of eventual rate increases, to a forward looking concern with deflation, accompanied by the promise of further rate cuts that leave short-term interest rates at very low levels for a long period of time, helps to lower longer-term interest rates and thereby encourages more spending.

The move by the Greenspan-led Fed to symmetric (neither too high nor too low) price level targeting, coupled with other stimulative forces that will be operating on the U.S. economy over the coming year, sharply increases the chance of attaining sustainable trend growth and lower unemployment for the U.S. economy. It marks a constructive departure from last year's counterproductive "return to neutrality" concept, whereby the Fed, irrespective of weaker growth and falling inflation, is driven to return to some abstract "neutral" fed funds target to avoid an imagined return to inflation.

To its credit, the Fed's Open Market Committee never embraced the "neutrality" concept and instead undertook last spring to disabuse nervous markets that the notion would lead to preemptive tightening. But for a time, the idea that the Fed would have to start tightening late last year to get back to a "neutral" fed funds rate kept longer-term rates higher and real yields higher for fear that the ability to employ short-term borrowing to support purchase of longer-term bonds would disappear. Such a disappearance of "positive carry," the spread between long-term and short-term interest rates, forces the sale of longer-term bonds. Many traders recall the rapid run-up in rates in 1994 when 10-year yields rose by 250 basis points as soon as the Fed began raising the federal funds rate.

Constructive Insurance against Deflation

The Fed's overt concern with avoiding deflation is buttressed by its observation that the existence of substantial excess capacity makes the likelihood of inflation very low, so low in fact as to render virtually costless the purchase of antideflation insurance with further rate cuts. By emphasizing deflation avoidance, the Fed offers an assurance to markets that short-term rates will remain low--or lower--for some time. Since longer-term rates are just a series of current and expected future short-term rates, the signaling from the Fed of a long period of stable to lower short-term rates has lowered long-term rates. Since Chairman Greenspan first voiced his deflation concerns in April 30 testimony to the Joint Economic Committee, yields on ten-year treasury bonds have fallen by 80 basis points without any further short-term rate cuts from the Fed. This substantial flattening of the yield curve as the Congress passed a stimulative tax cut bill has silenced the critics who argued that the tax cuts and resulting larger deficits would steepen the yield curve.

Contrary to the protestations of those trying to avoid "irresponsible" tax cuts--tax cuts that would raise deficits and thereby leave less room for hefty increases in government spending--the recently enacted tax-cut measures have boosted both stock and bond markets by raising hopes for higher growth and less risk of deflation. Markets respond well when central banks undertake sound antideflation policies while Congress and the president adopt pro-growth tax cuts. Both stocks and bonds can and have rallied when the central bank shifts to an appropriate forward-looking battle against deflation and away from a dangerous, backward-looking battle against inflation such as that which drove Japan into the trap of falling growth and accelerating deflation under its backward-looking Bank of Japan governor Masaru Hayami.

Coordinated Policies

Chairman Greenspan's new emphasis on stopping deflation before it starts could not have been better timed. It coincided with passage of a Bush package of tax cuts that will add nearly 1.5 percentage points to U.S. growth. It also coincided with a wise move to a market-determined-dollar stance by the Bush administration that will add further to U.S. growth by consolidating the roughly 10 percent trade-weighted depreciation in the dollar since last fall. The policy of letting markets set the value of the dollar without government interference further supports growth by forcing foreign central banks, concerned about disinflationary appreciation of their own currencies, to adopt more expansionary policies. The ECB has already responded by cutting short-term interest rates 50 basis points early in June. The combination of a weaker dollar shifting more demand onto U.S. goods and faster global growth should add another percentage point to U.S. growth by next year.

With substantial excess capacity, the dollar depreciation, like the tax cuts and lower U.S. interest rates, will mean higher growth without the usual danger of higher inflation that follows either a falling currency or falling taxes at times when too much demand growth is present. The global phenomenon of inadequate demand growth reverses the rules of prudent policy regarding currency, taxes, and interest rates. Anything that boosts demand growth is good since it helps to absorb excess capacity. 

Once faster demand growth has absorbed excess capacity, businesses will want to build more capacity. That means higher investment and a movement of the economy onto a sustainable growth path that increases employment for a growing labor force. If, eventually, after all these hoped-for steps--faster demand growth, pressure on capacity, higher investment spending, and more labor hiring--are taken, should rising prices eventually signal an overheating economy, the Fed can start raising rates to cool down growth. But thinking now about the need for eventual tightening in 2006 or later, is like never eating for fear of eventual weight gain. You can starve to death just as an economy can slip into deflation if monetary policy is kept too tight out of fear of eventual inflation. European Central Bank and Bank of Japan please take note.

Stronger Growth 

Taken altogether, the tax cuts, the weaker dollar, and lower interest rates over the entire yield curve should add 2 to 3 percentage points to growth over the coming year, even allowing for a 0.5 percentage point drag from higher state and local government taxes. With underlying growth tied to productivity growth at about 1.5 percent, total GDP growth should reach 4 percent by year-end. If the absorption of excess capacity and resultant higher investment growth boost hiring (as usually occurs during an economic recovery), then another percentage point could be added to growth as workers are absorbed back into the labor force and more paying jobs replace rising but temporary unemployment benefits. Then we would see a more typical sustainable recovery with growth above 5 percent for one or two quarters.

Market Response

Current behavior of U.S. financial markets indicates substantial skepticism about the prospects for a return to sustainable growth of 4 percent or above by next year. That is understandable in view of several false starts and painful reversals in equity prices that have been experienced by investors since March 2000. Skepticism is further reinforced by current lackluster economic data that will probably result in second quarter growth of something close to 1 percent. Even the third quarter may be too soon to expect a substantial rise in spending and output, since households may respond with a lag to tax cuts and since distribution of additional child tax credits will not occur until September.

The additional incentives for investment spending, more accelerated depreciation, and enlarged expensing provisions for small business are more likely to enhance the investment response to faster demand growth (probably sometime later this year) than they are to prompt higher investment growth in advance of faster demand growth. By the fourth quarter, however, a sustained increase in household spending should boost growth by enough to cause some companies to raise investment plans for 2004. Meanwhile, higher demand growth may be self-reinforcing if it is accompanied by an improvement in the outlook for profits and, thereby, supports higher stock prices. As stock prices rise, household balance sheets and corporate balance sheets improve, in turn, increasing the likelihood of further spending increases.

Future Market Signs of Recovery

If the unusual combination of stimulative policies improves growth by producing an unusually high critical mass of demand stimulus, some of the stimulus will eventually be automatically eliminated. As deflation fears ebb and growth returns, of course interest rates will rise as a sign of higher real returns on investment. The rise in the stock market and higher interest rates reflecting the prospect of a sustainable economic recovery will cause funds to flow into the United States and reverse the weakness of the dollar. That is precisely the kind of a strong dollar policy that President Bush had in mind when he advocated a stronger dollar at the recent G8 summit.

Higher interest rates, a stronger dollar, and higher stock prices are all symptoms of a desirable economic recovery. In reality, we should all be hoping for these developments to occur during 2004 because if they do not, it will mean that one of the most highly coordinated collection of stimulus measures assembled in the postwar period has failed to reignite growth. In that case, we will all be in serious trouble.

John H. Makin is a resident scholar at AEI.