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It's time for the Fed to come clean
As the economy sputters, Alan Greenspan is pursuing policies that are either deeply flawed or deeply cynical. Neither path is terribly reassuring.
By Jim Jubak
The Federal Reserve needs to come clean about its plans for the economy. No more hiding behind scary references to impending deflation. No more Greenspan doublespeak. If its the Federal Reserves intention, as I believe it is, to flood the economy with money until this slowdown cries uncle, then just say so. The central bank owes that clarity to everyone now struggling to plan for the financial future.
If the Fed intends to open the money spigots even further, which is how I interpret the most recent exercise in doublespeak, then once again it's taking steps that will muddle investors and savers ability to discern and measure financial risk in the markets and in the economy. And we all ought to be planning to cope with a resurgence of inflation, not deflation, somewhere down the road. Ill tackle these two problems that result from the Feds strategy in my next column and in my Wednesday night appearance on CNBCs Business Center. (Youll be able to find a transcript of that here on Thursday.)
The Federal Reserves public statement after the May 6 meeting of its Open Market Committee was a masterpiece of misdirection. The Fed said that the danger that the economic recovery had stalled had increased -- in Fed-speak, the bias had shifted from neutral toward a likely further cut in interest rates. With the Federal Funds already at a low, low 1.25%, another cut in rates would be a big step. Many economists think that 1% represents an effective minimum. Below that level, banks and money-market funds have trouble attracting cash and covering expenses.
But most of the post-announcement attention focused on a different point, the Feds statement that inflation was no longer the danger that the bankers feared most. That honor would now go to deflation. Federal Reserve policy would now be set in order to stave off the threat of deflation.
The fear factor
Deflation is an emotionally loaded term for many Americans and most investors. Inflation is the economic norm since the money supply and prices are rising most of the time, so deflation is unfamiliar and scary. The word immediately conjures up the years of the Great Depression, the last bout of economy-wide deflation that this country experienced. The mere word ratchets up the fear level among investors and among workers already deeply nervous about job security.
Whats so extraordinary about this impending war on deflation, to me, is that by any conventional -- and most unconventional measures -- there is no deflation in this economy. And its quite possible that the gauges used to measure inflation/deflation in prices are so corrupted by years of manipulated data that the numbers they spit out are meaningless for guiding the kind of fine tuning that the Fed now proposes.
I dont know about you, but this doesnt feel like a deflationary economy to me. OK, so the price wars between Burger King and McDonalds (MCD, news, msgs) make it possible for me to get my fast-food fix for a $1, and the price of a printer for my computer recently hit an amazingly low $109 (after mail-in rebate). But prices of big-ticket items that impact my familys budget the most continue to climb, particularly professional-service fees.
For example, homeowners are paying 6% more for insurance this year than last. Auto insurance is up 8%. College tuition and fees are up 6%. Health-care insurance is up 8%. It takes a lot of savings from that $1 value menu to balance out hikes like that.
And that doesnt even count the increases in state and local taxes that we all know are coming this year and probably next as states and cities try to balance their budgets.
Perception vs. reality
For most of us who live in this economy, inflation sure feels a lot worse than the official rate of 2.5% on average over the last three years.
But, wait a minute. If the official Consumer Price Index, calculated by the Bureau of Labor Statistics, is showing inflation, even if just moderate inflation, then why is the Federal Reserve worried about deflation?
The economists Ive talked to say the Fed is worried about the trend of prices in some sectors of the economy that had been showing the biggest increases. Health-care costs may not be about to go down, for instance, but the rate of increase may be moderating. Same with college tuitions. The theory is that if these key inflationary sectors begin to show a slower rate of increase than the economys overall rate, price inflation might actually turn negative. Deflation.
There is, of course, a common-sense rejoinder to this theoretical perspective. What, those of us who pay tuition bills might ask, is wrong with a slowing of what has been a horrendous march upward for those costs? Whats the matter with less of a hike in healthcare insurance or homeowners insurance?
But even if we keep the battle to the theorists home turf, the Fed still faces one huge problem in making its case: The inflation numbers are cooked and have been for years. Everybody knows it. Nobody knows how big the distortion is or what a true measure of inflation might show.
How the numbers are cooked
Heres the problem with the numbers. The government measures inflation at the consumer level by looking at a basket of goods and services, 80,000 price quotes a month. That basket represents the Bureau of Labor Statistics' best model of what you and I buy.
The Bureau then modifies those numbers to account for improvements in the quality of the goods and services purchased. If a car that cost $22,000 in 2002 now sells for $22,500, but the 2003 car comes with improved air bags and a better braking system, the Bureaus adjustment might show that the inflation between 2002 and 2003 isnt $500 but zero. Or even less. That kind of negative inflation -- deflation -- attributed to product improvement has certainly been the case in the computer sector, where $2,000 now buys you a much better computer than $2,000 five years ago.
Again, on a common-sense basis, this system clearly has its flaws. Yes, I may be getting more car for my $22,500 in 2003 than for my $22,000 last year, but an extra $500 is still coming out of my pocket.
Statistically, the system is subject to challenge, too. To account for increases in product quality, the government converts prices and sales measured in dollars to prices and sales measured in units of product quality, a very subjective measure in many cases. No less than 18% of the GDP numbers are put together using this kind of quality adjustment. And the effect in individual sectors can be huge: Before adjusting for quality, computer sales were stagnant in 2002, according to calculations by Grants Interest Rate Observer. After adjusting for quality, computer sales climbed 18% in 2002.
Good luck to the Fed in its efforts to fine-tune inflation/deflation with statistics of this quality.
Where's the deflation?
Stricter economic constructionists point out that none of this has anything to do with inflation/deflation. The rise or fall of prices is a symptom, an effect, of inflation/deflation. Inflation/deflation is defined as, and is to be measured by, increases and decreases in the money supply. When the money supply increases, thats inflation, and as a result, most of the time most prices rise -- among them the price of financial assets such as stocks and real estate. When the money supply decreases, thats deflation, and as a result, most of the time most prices fall.
Using these definitions, its even harder to see what the Fed sees that qualifies as deflation. Every single measure of the supply of money in the economy is showing solid increases over the last three, six and 12 months. (Each measure, M-1, M-2 and M-3, defines money in a slightly different way.) And theyve all been growing faster in the last three months than over the previous 12. In other words, the rate of growth is accelerating. M-1, for example, increased 8.8% in the last three months, up from a 4.2% rate of growth in the last 12 months. M-2, the most widely followed definition of money, grew by 6.8% in the last three months, and growth in the last month was at the highest rate in the last 15 years.
So wheres the deflation?
There is certainly a big problem in the economy. Even as costs of many things, including labor, are falling, corporate profits are declining, too. Profit margins are near a postwar low, and revenue is still falling for most industrial companies. That all means that almost no CEO is investing in new plants or equipment. In the short run, that has created a true recession in parts of the economy. In the long run, that lack of investment undermines the productivity growth thats needed to keep U.S. products competitive in the world and to give the United States a chance to pay back its staggering debt to foreign investors.
You dont have to look hard to find the cause of the problem. The massive over-investment in capital goods produced by the cheap, cheap money of the financial bubble in the late 1990s has led to 20-year lows in factory utilization. Nobodys making any money because theres always somebody out there willing to cut prices to keep a factory running at 75% capacity.
For this, if Im correct in interpreting the May 6 Fed statement, Alan Greenspan & Co. have proposed a solution that looks like this: Run the printing press (and increase the money supply) until the economy gets growing again. Increasing the money supply will send interest rates lower so consumers might be able to keep spending by refinancing their houses yet again or spending down even more of their home-equity lines. Companies will be able to restructure their balance sheets to reduce the interest rates they pay and increase profits. And at some point, money will get so cheap that CEOs will green-light new capital spending even if they still dont have full factories.
In other words, more of the same.
Time to rethink
Maybe thats all it will take. But I have to wonder if the failure of this strategy so far means that it might be time to rethink the nature of the whole problem facing the economy.
If the problem with corporate margins is related not to domestic supply and demand, but to global supply, then increasing the money supply wont be especially effective. If your company is competing with a Chinese enterprise that has subsidized access to capital and a government willing to pick up the losses, perhaps indefinitely, as long as the business produces jobs, then its hard for me to see how the Fed can lower rates or increase the money supply enough to make a difference.
Or if the problem is demographic -- in other words, that falling U.S. profit margins are the result of the aging of the U.S. workforce, which increases pension and healthcare costs -- then again, its hard to see how the Fed can solve it with monetary tools.
Or if the problem truly isnt economy-wide, but rather, specific to individual industry sectors, wouldnt targeted federal spending on the demand side be more effective than flooding the entire economy with more money? How about accelerating spending and increasing it on the next generation of the Internet backbone, for example, if the problem is excess capacity to build networking gear?
Shouldnt we, as a nation, at least be talking about the other potential solutions? The only debate going on right now is over the size of the tax cut. And to the degree that plan has any economic validity at all, it focuses on another attempt to goose consumer spending by putting more money in taxpayers pockets and throwing a few capital-equipment tax breaks at industry. In my opinion, it all too closely resembles the Feds strategies to date.
Its this debate that the Fed has choked off with its cry of Deflation.
Chilling possibility
There is one other chilling possibility that crosses my mind. Maybe the Fed isnt bull-headedly locked into one set of policies. And maybe it didnt raise the deflation flag as a way to buttress support for those policies.
Instead, maybe the Fed has looked around at the political landscape and concluded that for the foreseeable future the monetary game is the only one in town. Hoping for potential solutions that require political action by Congress and the White House is just not realistic. Raising the specter of deflation, in this scenario, buys the Fed time and keeps foreign investors from doing even more damage to the dollar. The Fed may have concluded that its solutions are the only ones likely to be put into action soon enough to do any good.
Some choice, huh? A Fed pigheadedly pursuing deeply flawed strategies; or a brilliantly cynical Fed that knows those deeply flawed policies are the economys best chance.
I just hope the patient recovers before the doctors show up with their medicine and say, Open wide.
New developments on past columns
Much maligned target prices offer superior payback
Another increase in production from Tom Brown (TBI, news, msgs) this quarter, plus high prices for natural gas, enabled the company to report first-quarter earnings of 49 cents a share. Thats quite a pop from the net loss of 47 cents a share in the first quarter of 2002. What the company calls discretionary cash flow climbed to $62 million, an increase of 135%, as the company continued to cut spending on exploration and drilling. But with gas prices now steady at higher levels, the company is upping spending on those activities, and it forecasts a 14% climb in production volume by the fourth quarter of 2003. Extra supply will also come from the recent deal to acquire Matador Petroleum for about $390 million in cash and assumed debt. As of May 16, Im setting a new target price of $34 a share by September 2003.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: AOL Time Warner, Comcast and Continental Airlines. He does not own short positions in any stock mentioned in this column.
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