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Is Easing the Answer?

By Michael Englund That the Federal Reserve will cut the Fed funds target rate at the June 24-25 meeting of its policy-setting arm, the Federal Open Market Committee, is hardly in doubt. Many FOMC members have signaled that an easing is imminent. But several of the policymakers who have been quiet on the matter are probably still unclear as to why the Fed is easing at all.

We at MMS International believe that the pre-meeting "Fedspeak" this time around was as much an attempt to warn the market of the impending move as an effort to start the debate in a public forum. The argument will rage behind closed doors at the two-day policy get-together, and that discussion will provide the backdrop for the decision regarding the size of the easing -- and the tone of the policy statement released after the meeting.

We expect the central bank to come across with a 25-basis-point cut, while issuing a relatively mixed economic assessment. Our guess is that, similar to the Fed's most recent policy gathering, Chairman Alan Greenspan will achieve consensus with a mixed policy statement that will refrain from forcing the Fed's hand again at the next FOMC meeting on Aug. 12.

STRENGTH OF DISSENT. It's worth noting that the market would probably not be looking for any easing at all from this meeting had it not been for the recent barrage of comments from Fed officials regarding deflation risks (see BW Online, 5/6/03, "The Fed Identifies a New Peril").

Indeed, the fact that the Fed has had to pull the markets into the easing camp with frequent and repeated comments provides an important barometer of the likely strength of dissenting opinion regarding the "should cut" vs. "will cut" distinction. (Analysts and pundits who follow the Fed generally avoid the academic discussion of what the Fed "should" do, as opposed to what action it is likely to take.)

Dissenting members of the FOMC will probably voice the market skepticism about the need for an easing at this time, as well as the easily constructed laundry list of reasons why the risks to the expansion remain skewed to the growth side. For those who doubt the force of such a list, here's a review.

KICKING IN. For starters, this policy cycle can arguably be seen as revealing a more powerful and preemptive use of fiscal and monetary stimulus than any prior post-World War II cycle. The result has been a virtual lack of recession in the 87% of the economy that includes consumption spending, government purchases, net exports, and residential investment. The entire downturn has been seen in the fixed investment and inventory data for business, which constitute only 13% of gross domestic product.

Much of the economic stimulus in the pipeline is only now taking effect, as yields on longer-dated securities have just recently pulled back a significant degree, and a big portion of the combined tax cuts of the last three years is expected to kick in during June and July. All this is occurring while "real" interest rates (as adjusted for inflation) have fallen from cyclically firm levels to historic lows that now reflect extraordinarily depressed nominal levels overall.

The dollar is falling, thereby providing a robust stimulus for net exports, while the stock market has staged a solid recovery. The snapback in equities has taken the tired claims of "negative wealth effects" (the notion that declining values of assets like stocks induce consumers to cut back on spending) out of the discussion -- we hope for good.

JUDGE THE LAG. And finally, despite Fed rhetoric about deflation, the U.S. has probably already seen the bottom of the current price cycle (see BW Online, 5/6/03, "Why Deflation Fears Are Overinflated"), with help from the temporary downward energy-price correction in April that's now finished.

At best, the Fed is basking in the glow of the "long and variable lags" in the relationship between the business cycle and inflation. Until now, the recession of 2001 has had the lingering effect of depressing inflation, but this impact will soon be replaced by upward pressure from accelerating aggregate demand -- and a recovering business sector -- which generally translates into inflation pressure as the economy enters the third and fourth years of an expansion.

Of course, the Fed chairman can correctly note that the steepness of the yield curve -- the spread between rates on the two-year Treasury note and the 30-year Treasury bond -- makes the level of the Fed funds rate largely irrelevant anyway. This is because longer-term yields in the corporate bond, municipal, and mortgage markets already reflect the likelihood that further short-term rate reductions will need to be reversed quickly during the ongoing business expansion. So any cuts in the Fed funds rate are unlikely to place noticeable downward pressure on the interest rates that businesses and individuals are actually paying for credit or loans.

Using that logic, it's somewhat easy to see why policymakers may be thinking it advisable to provide this little public shot in the arm to confidence -- one that can always be taken back in 2004 as the economy recovers. Ultimately, Greenspan & Co. will search for the proper mix of policy easing and statement rhetoric to maximize the boost to business and market confidence -- while corralling potential dissenting voters and maintaining some truthfulness regarding the actual economic outlook. Englund is chief economist for MMS International

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