Fed gets economy’s ducks in a row

The Federal Reserve’s reduction of the fed funds target rate to 3.75% late last month put the economy a step closer to an inflection point, at which the momentum toward slower growth finally turns toward an acceleration in economic activity.

As expected, economic data for the second quarter continue to depict an economy that may be contracting. But the data are backward looking, and for the most part cover a period during which neither the tax cut nor monetary policy were in a position to reverse the negative tide.

Improvements in both tax and monetary policies within the last month and a half could prove to be the catalysts that tip the economy back toward growth. As June and July economic data become available in July and August, we will be looking for early signs of better times ahead.

The alignment of monetary policy with economic growth is the most significant change in our outlook of the U.S. economy and financial markets. Until May 15, the overnight fed funds target rate was above the yield on the two-year Treasury note, the longest of the short-term maturities. Although the Fed had been lowering interest rates starting in January, it was forced to limit the growth of the monetary base – the part of the money supply it controls – in order to keep the fed funds rate artificially high.

As a consequence, the Fed did not actually ease monetary policy until May 15, when it caught up to the decline in market interest rates for the first time since May 2000. Since then, the growth in the monetary base has accelerated. In addition, the downward trend in gold prices has stopped, with gold in recent weeks trading in a narrow range of between $265 and $272 an ounce.

Falling commodity prices in general, and the price of gold in particular, indicated that a shortage of dollars relative to goods and services persisted until mid-May.

Ending the downtrend in commodity prices signifies that the Fed may be shifting policy toward targeting a stable price level, as opposed to a rate of economic growth or stock price appreciation that it had deemed appropriate. A rapid deceleration in consumer price inflation to annualized rates below 2% is possible before yearend, and it will be a significant harbinger of stronger growth in the year ahead.

The tax cut, specifically the marginal tax rate reductions, also may help to turn the momentum of the economy toward economic growth. Tax rate reductions, unlike tax rebates or tax credits, reduce the domestic barriers to commerce, just as a reduction in tariffs reduces the barriers to international trade. Whenever the barriers to trade are reduced, inevitably people will find new ways to do business with each other. That’s what economists call economic growth.

This year’s tax rate relief, however, is tiny. Under the new law, all marginal tax rates above the 15% bracket have been reduced by 1 percentage point effective July 1. A midyear tax cut means that half the rate reduction is retroactive to the first of the year, and the remainder takes effect Jan. 1, 2002. That’s it for tax rate reductions until Jan. 1, 2004.

Nonetheless, the overall impact of the tax bill is still positive. Small-business owners are likely already calculating a 1% improvement in their after-tax cash flows, which, on the margin, will allow them to stabilize or expand their businesses. But tax cuts can’t help the economy until they are known. And this tax cut wasn’t known until Memorial Day, and hence would have no effect on May economic activity, and little effect on June activity.

Compelling evidence that the improved policy environment has turned the economy toward growth will not be available for at least another month.

In the meantime, second-quarter GDP and corporate profits are likely to reflect the deceleration in economic growth through May. And with uncertainty on the rise, investors may be inclined to discount better times until the timing of the recovery become more clear.

In addition, the prospect of better times ahead is far from assured. The spread of the electricity crisis throughout the Western half of the United States is a significant risk to the short-term outlook. Moreover, the movement toward free trade has taken steps backward, including President Bush’s protectionist moves against steel and lumber imports.

However, the improvements in tax and monetary policies point to a resumption of economic and profit growth by the end of the year.

One straw in the wind consistent with that view is the uptick in the Conference Board’s composite of leading economic indicators, which was largely due to improved monetary policy. That’s far from conclusive evidence, but it does support our view that the transition toward growth and a more positive environment for equities is under way.

Charles Kadlec is a managing director with J.&W. Seligman & Co. Inc., a New York money manager.