Kemp: An Open Letter to Alan Greenspan
Published November 27, 2000
Distributed by Copley News Service
A while back I expressed concern that the economy was teetering on the verge of a hard landing rather than the soft landing you envisioned when you announced 18 months ago you were going to slow down the economy in order to fight inflation. You and I have been friends for a long time, and I couldn't imagine that you really believe that too much economic growth and too many people working cause inflation.
But now I learn in Bob Woodward's new book, Maestro, that not only do you really believe this baloney but that you actually compared your theory of a soft landing to Albert Einstein's theory of relativity. Whoa, Mr. Chairman! Get a grip. Because so much is at stake, I have decided to appeal to you publicly to reassess how and where you are directing this economy.
Since I wrote that column, economic indicators have revealed additional weakening in the economy. The NASDAQ, which represents the new-era economy, now resides in negative territory for the year after falling 40 percent to below 3,000, and the Dow Jones industrial average is likely to close the year with a loss for the first time in 10 years.
Disappointing corporate profits reports are the clearest sign yet that the Fed's decision 18 months ago to raise interest rates has had a deleterious effect on the real economy. Recent industrial production statistics reveal that the manufacturing sector is probably already in recession, with manufacturing output falling 0.5 percent in October. The high-tech sector is clearly in a slowdown. More than 130 dot-coms have closed their doors this year, 20 in October alone. No evidence of inflation is anywhere in sight, other than the price of oil, and we both know that is a supply phenomenon, not a monetary phenomenon.
In October, the “core” producer price index fell 0.1 percent, and the consumer price index has increased even less than last year despite the run-up in oil prices. Notwithstanding the Fed's repeated warnings about “cost-push” inflation due to tight labor markets, there is no evidence of it even in the service sector where prices are presumed to be sensitive to wage increases. Long-term interest rates are 100 basis points below overnight rates.
The chart shown by clicking here plots the Fed Funds rate and the price of gold. You have said gold is one of the best inflation indicators, yet it is signaling deflation, not inflation. Still, the Fed decided two weeks ago to deny the economy much-needed liquidity by maintaining the Fed Funds rate at 6.5 percent. The Fed also sent markets a worrisome signal that it will keep the economy on short liquidity rations during the foreseeable future by maintaining its so-called “bias” toward tightening on the grounds that the economy might be growing too fast and inflation may be just over the horizon.
In the context of the historical pattern depicted in the chart, the Fed’s stubborn insistence on fighting a phantom inflation by targeting the stock markets and choking off economic growth is extremely dangerous. Mr. Chairman, I am greatly concerned that the Fed may be repeating the same mistake it made back in 1989 and 1990 when it hiked up interest rates and kept them too high for too long, which contributed to a recession within a year.
In mid-1986, when the economy weakened but the Fed failed to drain excess liquidity, inflation re-ignited and the price of gold began to rise. The Fed failed to heed this inflationary signal and actually lowered interest rates six months after the inflationary gold signal was flashed. The central bank continued to be slow off the mark for another full year in tightening monetary policy. During this 18-month period, the price of gold rose 43 percent, finally peaking at $500 an ounce when the Fed at last began to drain excess liquidity from the economy. But as is typical when central bankers use their discretion and seat-of-the-pants judgement rather than a market-based rule to make monetary policy, the Fed jacked interest rates too high and kept them there too long.
Eighteen months ago, the Fed embarked on another round of tightening that has raised the Fed Funds rate from 4.5 percent to 6.5 percent. Only this time around, the Fed jumped the gun and exhibited incredible hubris in professing to divine future inflation while the price of gold and other inflation indicators were continuously falling. As the chart suggests, the Fed may already have kept monetary policy too tight for too long, giving one reason to fear that if the Fed does not lower interest rates immediately, it will soon tip the economy into a recession.
Given the thin margin with which the next president will have to govern, it is especially troublesome that he may be taking office just when the economy is heading toward a possible hard landing. The Fed's earlier refusal to lower interest rates now makes it urgent for whoever enters the White House to move immediately both to cut tax rates and the regulatory burden. I hope you lend the next president as much assistance in cutting tax rates as you did the current president in raising them.
Jack Kemp is co-director of Empower America and Distinguished Fellow of the Competitive Enterprise Institute.
Copyright © 2000 Copley News Service