Central bankers have an exasperating habit of abandoning the right policy course, but only after careful consideration. After a prolonged period of economic stagnation and absence of investment spending that follows an equity market bubble and overinvestment, it is necessary for the central bank to signal reflation. This must be done decisively by stimulating demand and growth with unconventional measures aimed specifically at generating an expectation of higher inflation. The Federal Reserve had begun to follow this correct course, but upon further reflection has backed off.

 

Dangerous Return to Orthodoxy

Specifically, by abandoning unconventional reflationary measures at its June 25-26 midyear meeting, after having hinted strongly that they would be employed, the Fed has jeopardized a sustained U.S. economic recovery. Chairman Greenspan's more explicit statements during his July 15 midyear report to the House Financial Services Committee, indicating that the Federal Reserve Open Market Committee (FOMC) had determined unconventional reflationary measures to be unnecessary while reiterating a promise to keep short-term interest rates low (or lower) for "as long as it takes to achieve a return to satisfactory economic performance," had a hollow ring to them. After all, 550 basis points of short-term interest rate cuts over the prior thirty months had, so far, proved inadequate to achieve a return to "satisfactory economic performance." Markets were left to wonder why more of the same would do the trick.

For those with doubts about the recovery, Chairman Greenspan offered--yet again--the forecast of a recovery beginning in the second half of this year and continuing at an accelerating pace into next year. That outcome is, of course, much desired, but the chairman failed to address the fact that six months ago the Fed's forecast for real growth during 2003 was about 3.5 percent. Given an estimated growth rate during the first half averaging 1.7 percent, achieving that target would require a 5.3 percent growth rate during the second half of 2003--too much of a stretch even for the optimistic Fed chairman. So, while assuring Congress that the U.S. economy was about to recover, the Fed supplied a lowered 2003 growth forecast of about 2.5 percent, thereby implying a more plausible average 3.3 percent growth rate during the second half of 2003. At the same time, the Fed's inflation forecast for 2003 was lowered and for 2004 the projected inflation range included an inflation rate of three quarters of one percent.

Skepticism in Congress

In view of the Fed's optimism about higher growth in the latter part of the year and an utter lack of inflation fears, members of Congress might have been forgiven for asking the chairman why the Fed in June disappointed markets with a rate cut of only 25 basis points. The central bank compounded the markets' disappointment with a signal that unconventional though more aggressive stimulative measures that had been hinted at before the meeting were not likely to be undertaken.

As Senator Paul Sarbanes, (D-Md.) pointed out to Chairman Greenspan during still another midyear review, this one before the Senate Banking Committee, the Fed had been downgrading its forecast growth for 2003 for a year. Last July, the Fed had forecast 3.5 to 4 percent growth for 2003, only to lower it to 3.25 to 3.5 in February and then, as already noted, to 2.5 to 2.75 percent for the chairman's July 2003 testimony.

Senator Sarbanes made the following observation: "Are the models that you are using at the Fed overly optimistic, or have we all fallen into the trap of believing that there is a mythical recovery which is just around the corner? I mean, in all three of these years now the Fed has really been off the mark on its projections, overly optimistic consistently."

Chairman Greenspan openly acknowledged the Fed's forecasting errors and Senator Sarbanes suggested that those errors "would lend some weight to the view that we have a more serious economic situation on our hands than is being generally acknowledged or admitted to." Replied the chairman, "Oh, there is no question that that is the case."

Need for a Price-Level Target

In light of the persistent underperformance of the economy and the Fed's continued reliance on traditional measures of monetary policy, including adjustments of the federal funds rate that determine short-term interest rates, it is important to ask what, specifically, would be the elements of a sustainable recovery. It is also important to explain why the Fed's actions since early June have jeopardized the chances for that urgently needed recovery. Its abandonment of possible purchases of long term Treasuries and projection of faster growth have boosted long term interest rates by nearly a full percentage point while expectations for inflation have, if anything, dropped. That constitutes a rise in real interest rates--a significant barrier to resumption of higher growth.

The Fed had seemingly embarked on a course of targeting price stability in the face of possible deflation when it inserted into the press release after its May 6, 2003, meeting the following phrase: "The probability of an unwelcome, substantial fall in inflation [the Fed's code for deflation], though minor, exceeds that of a pickup in inflation from its already low level."

This statement of concern about possible deflation was followed by public statements by Fed board members and staff that the Fed was actively considering unconventional measures, such as direct purchase of longer-term treasury securities to stimulate demand growth. This consideration seemed appropriate in view of the fact that the fed funds rate (the Fed's usual policy instrument) was nearing its limit of zero. More compelling, and unaddressed specifically by the Fed, was the uncomfortable fact that the then heretofore 525 basis points of cuts in the Fed funds rate since January 2001 had failed to produce a recovery. When one stimulus measure fails, it is appropriate to consider employing another, not just because the failed measure may be approaching its feasible limit, but because it simply has not worked.

A proactive Fed move to direct purchase of longer-term treasuries would be effective precisely for the reason that it is usually avoided. It would raise inflation expectations, thereby increasing demand growth and lowering the demand to hold sterile cash and liquid assets. Central bankers are habitually--and in most cases appropriately--loathe to elevate inflationary expectations. But if a central bank targets a stable price level--sustained inflation of 1 or 2 percent given an upward bias in most inflation measures--it must act to raise inflation just as aggressively when it falls too low as it acts to lower inflation when it rises too high.

The habit of moving aggressively to lower inflation that has become too high is so firmly ingrained in the minds of central bankers that they cannot bring themselves to undertake measures to boost inflation when it is too low--at least not until deflation has actually taken hold and the task of pushing prices back up is far more difficult. This problem has become amply evident in the sad case of Japan. Ironically, the Fed is following the same path followed by Japan after having studied that country's drift into deflation as a means to avoid the same experience for the United States.

There is another, more subtle point that many central bankers--at least judged by their actions--have failed to grasp. It is best to adopt a price level target consistent with a modest measured inflation rate of 1 to 2 percent. A price level target means that if inflation becomes deflation, the central bank is committed to push inflation to a level that overshoots its ultimate target, thereby providing a sharp incentive for households and firms to raise spending and thus to provide the wherewithal to end deflation. The promise that deflation will prompt measures aimed at an overshoot of inflation--a catch-up phase of inflation to achieve a stable price level target--results in a substitution out of sterile cash and liquid assets into goods. The demand boost increases output and eventually investment. The increase in investment adds to capacity and thereby mitigates further inflation pressure. Finally, elevated demand pressure boosts the need to raise employment, thereby reinforcing demand growth, a key element of a sustainable recovery.

No Risk of Inflation

Naturally, at some future point, the Fed will need to act to reign in demand growth. After demand growth has for a time outrun sustainable output growth, inflation will return. Indeed that very prospect fosters a recovery of investment. But as the Fed and others have correctly emphasized, existing excess capacity coupled with productivity growth of around 2.5 percent should permit sustained growth at or above 4.5 percent for two years before inflation pressures reemerge. The process of reestablishing a balance between demand growth at a higher sustained level above 4 percent for a prolonged period of time is the process that lowers the unemployment rate from its current elevated level of 6.4 percent back below 5 percent and toward the 4 percent level achieved in a non-inflationary environment at the end of the economic expansion of the 1990s.

Overreliance on traditional measures of monetary policy, such as further downward adjustment in the federal funds rate, is exactly the wrong strategy to follow after three years of demonstration that reductions in that rate are not effective in resolving America's problem of chronic excess capacity. However, at his July congressional reviews before the House and Senate, Chairman Greenspan indicated strongly that the FOMC will continue to meet any economic weakness that emerges with reductions in the fed funds rate, now at 1 percent. That was a serious mistake for two reasons: First, it signaled that, should a second-half recovery fail--again--to appear, the Fed's response will be to cut the federal funds rate perhaps to 25 basis points or even to zero, thereby delaying by at least six months any proactive reflationary measures such as the direct purchase of longer-term Treasury instruments. However, the chairman failed to provide any reasons to suppose that an additional 75 basis points in fed funds rate reductions will spark a sustainable recovery in 2003 given that, as noted earlier, 550 basis points in such cuts since January 2001 have failed to do so.

The second problem with the Fed's retreat to orthodoxy was that Chairman Greenspan's statement to Congress suggesting that direct purchase of longer-term treasuries has been rejected--at least until after another round of traditional measures has failed--coupled with the FOMC statement in June resulted in a rise in long-term yields of nearly a full percentage point. If that increase persists or if technical rebalancing of mortgage portfolios in the $4.5 trillion mortgage market produces even higher long-term interest rates, the damage to the economy and the delay of an effort at reflation will have serious negative consequences.

The Outlook for U.S. Growth

Last month I expressed optimism that 4 percent growth was possible by year-end based on three factors: the substantial fiscal stimulus contained in the recently enacted Bush package of tax cuts; the weaker dollar that would help to shift demand onto the output of U.S. producers; and, most importantly, the proactive employment by the Fed of unconventional measures aimed at stimulating the economy that included the direct purchase of long-term securities as a means to raise inflationary expectations.

While the tax cuts remain in place and will undoubtedly help to stimulate growth later this year, a familiar "Catch-22" has emerged with respect to the other two legs of the U.S. recovery stool. Hopes for recovery have produced a restrengthening of the dollar and, along with changes in the focus of the Fed's monetary policy, a sharp rise in interest rates. These two events make recovery less likely unless they are actually symptomatic of a rise in the real return on investments in the United States. Unfortunately, there is little direct evidence available to date of a spontaneous rise in the expected return on investment in the United States and an impending increase in capital spending.

The real danger is that, as in 2001, the tax cuts will produce a temporary surge in demand accompanied by two or three quarters of higher growth followed by another relapse into lower growth. This scenario is distressingly similar to the Japanese scenario during the 1990s, when fiscal stimulus packages excited growth for a time but no sustainable recovery followed, either because taxes were actually increased when growth reappeared or the central bank was too passive in dealing with persistent disinflation that eventually turned into deflation.

Watch Investment and the Fed

In the summer of 2003, markets and policymakers are left waiting to see if the flow of data on the U.S. economy confirms the Fed's optimistic outlook for a recovery starting in the fall or shows continued sluggishness. The latter outcome would likely reflect higher interest rates shutting down the refinancings that have been so important in sustaining household spending, while higher state and local taxes soften the impact of federal tax cuts enough to keep demand growth tepid. As Chairman Greenspan has indicated, we probably cannot expect much help from abroad and, in fact, a strengthening dollar aided by continued dollar purchasing by Asian central banks represents another headwind for the U.S. economy to overcome.

To repeat, perhaps the worst outcome, the one that I fear most and one that carries a 50 percent probability of occurring, would be a brief surge in the economy thanks to tax cuts with a relapse back to subpar growth in 2004. The key is to watch investment spending. If the economic bounce that follows from tax cuts appears strong enough, companies will desire additional capacity and investment spending will strengthen. An annualized growth rate of investment spending above 10 percent would be most encouraging since it would suggest that companies are doing more than simply maintaining capacity, but rather actually adding to capacity on the expectation that additional output could be sold at a profit.

A recovery would be much closer at hand if the Fed had remained determined to fight the threat of deflation as intensely as it has fought the threat of inflation in the past. Let's hope that the Fed soon makes a virtue of necessity by adopting a price-level target and pursuing it with active reflationary measures.

John H. Makin is a resident scholar at AEI.