Last week, Alan Greenspan & Co. told us that the Federal
Reserve's monetary policy is "accommodative" to economic recovery, which in
a perfect world would be a realistic assessment. Problem is, this is far
from a perfect world.
While the Fed has been increasing the money supply at a roughly
10 percent rate in recent months, overall financial conditions in the
economy have tightened -- countering the Fed's positive moves. In the wake
of the Enron collapse, we've witnessed the unraveling of companies like
Global Crossing, Tyco, Adelphia and now WorldCom. Insider-trading probes
have ImClone plunging and Martha Stewart Living Omnimedia teetering. In the
media sector, Vivendi and AOL Time Warner look shaky. Bristol Myers and
Xerox are feeling the pinch. And the list goes on and on.
This year's crash and burn of major U.S. companies has been a
deflationary event -- one that's taking a toll on the financial system and
the economy. It has caused a major decline in individual wealth, net
balance-sheet worth and asset values. Major banks like JP Morgan Chase and
Citigroup are stuck with nearly worthless paper and slumping earnings.
Venture-capital funds are still dormant. The market for initial public
offerings, which was struggling to reopen, is now again closed.
The only really prosperous market in recent months has been
Treasury bonds, which have benefited from dropping interest rates. Yes, this
may be fortuitous for home loan mortgages, but this kind of interest-rate
decline among credit-risk-free government securities is representative of a
new bout of temporary deflation.
Some have suggested the Fed made a mistake in March when it
shifted its policy bias to neutral (meaning it would make no adjustments to
the key fed funds interest rate) from its earlier
recession/deflation-fighting stance (meaning it would cut rates to stimulate
the economy). Given the unexpected deflationary decline in stock averages
this year, the central bank might want to consider re-entering the fight.
The door should be left open for the possibility of another easing move. At
the very least, the central bank should reassure the public that the
money-injection spigots will be left open wide.
The Fed funds futures market has already figured in some
rate-cutting. CNBC's Bill Griffeth has observed that the shift in Fed funds
futures from a 3.5 percent expected target rate by yearend to the current
1.75 percent target rate reflects a defacto tightening in the credit market.
This is a good point. If corporate treasurers and bank-loan officers are
pulling back from expectations of brighter financial conditions, there is in
fact a mild internal tightening going on in the financial system. Greenspan
should think about following their lead, because time may be running out.
In March of this year, the stock market hit its post-9-11 war
peak. Since then, it has dropped 15 percent, losing about $1 trillion in
household wealth, and it has been accompanied down by an interest-rate
decline in Treasury notes. In normal circumstances, a falling interest rate
for Treasuries would be a plus for shares, but at the moment wealth and
assets are contracting. This is a deflationary pattern, not a stimulative
one. The $12 drop in gold is also symptomatic of the new whiff of deflation.
If Treasury rates and stock averages continue to descend, it
will set off alarm bells over the health of the economic recovery. And then
we'll be left with a battle of perception. Should investors follow the stock
market down, or the economic indicators up?
Remember, there's still a lot of good economic news out there.
While consumer spending has slowed in this year's second quarter, the
pick-up in industrial production and shipments of durable goods suggests
that the business-investment sector is in fact recovering. As this business
recovery takes hold, it will translate into higher incomes and hence more
consumer spending. These are the true recovery forces, and they're alive and
well. But this rising-economy data is disconnected from the reality of
falling stocks. It's a disconnect that can't go on forever.
Last week, we also heard from President Bush, who showed some
welcome anger over the collapse of corporate ethics. Poll after poll clearly
shows that the public gives Bush high marks on ethics and morality -- a bit
different from the marks Clinton received in his final years. If Bush can
keep the White House on this message, he can successfully use the bully
pulpit to restore a truly moral climate in the business and financial
Ending the moral amnesia in the executive suites will go a long
way toward restoring investor trust and terminating the stock-market bear.
But Greenspan has to remain on guard. These days, status-quo "accommodative"
just won't do.