Other Views: Better monetary policy, better times

Once again, all of us are on the edge of our seats, counting down to tomorrow’s Federal Open Market Committee meeting. As investors and financial advisers, we need to watch for actions by the Fed that will, along with tax rate reductions, produce accelerated economic growth and a resumption of corporate profit expansion.

The equity market usually anticipates such policy developments six to eight months before they affect the economy and company earnings. In the near term, therefore, the evolution of monetary and tax policies will compete with earnings warnings and disappointments in driving the markets.

Thankfully, the Fed’s recent actions to meet the global demand for the U.S. dollar are beginning to reverse one of the main drags on last year’s economy. An additional half-percentage-point interest rate reduction tomorrow would put us a step closer to ending this period of flagging economic growth. But we’re not out of the woods yet.

The U.S. economy managed to grow at a 2% annual rate during the first quarter. But that better-than-expected growth overstates the patient’s health. The improvement in the trade account, for instance, contributed 1.4 percentage points to first-quarter growth.

The decrease in the trade deficit, however, was fueled not by exports – which declined – but by imports falling at an 11% annual rate. In other words, the rest of the world absorbed a significant part of the shock of the U.S. slowdown.

In addition, ongoing price cuts meant that the reported contraction in the technology sector was understated. In inflation-adjusted terms, for example, expenditures on information-processing equipment and software contracted at a 6.4% annual rate.

But nominal sales fell at an even faster annual rate of 12.8%. The story is even worse if we look at the computer industry, which posted a 3% annualized decline in real terms, but collapsed at a 30% annual rate in nominal terms. No wonder technology companies are reporting sequential drops in revenues and lower margins.

Much of the weakness can be traced directly to last year’s overly tight monetary policy. The Fed promised a decline in inflation as the benefit of its move to slow the economy, increase unemployment and reduce the “wealth effect” by reining in rising stock prices.

The economy has certainly slowed, unemployment is up, and more than $4 trillion of stock market wealth has been destroyed. However, inflation is up. The gross domestic product deflator, a broad measure of inflation, accelerated to a 3.2% annual rate in the first quarter, double its rate of advance in the third quarter of last year. The Fed failed to deliver on its promise.

Fortunately, this dynamic is in the process of reversing. The pivotal point for Fed policy in this cycle may have been its April 18 decision to reduce the fed funds rate a half point, to 4.5%.

The move, which caught the markets by complete surprise, received a resounding welcome. That day, the Standard & Poor’s 500 stock index rose 3.9%, and the Nasdaq Composite Index rose 8.1%. At the same time, the yields on 10-year Treasury bonds declined, indicating an improved longer-term outlook for reduced inflation.

positive signs

Moreover, unlike in January, when the dramatic moves to reduce interest rates led to a false rally in the stock market, our monetary indicators today have begun to point in a positive direction.

First, the monetary base has again begun to grow at a pace sufficient to support economic growth.

Second, the Fed has narrowed the gap between the overnight fed funds rate and the yield on the two-year Treasury note to less than 0.3%, from more than 1%, suggesting that the Fed’s target rate is now nearly aligned with market rates.

And finally, the downward drift in commodity prices in general, and the price of gold in particular, has been arrested. During the first quarter, the steady decline suggested that the monetary supply was insufficient to meet global demand.

But at the beginning of April, when the Fed began to increase the growth rate of the monetary base, commodity prices stopped falling. That is important evidence that the Fed is supplying all of the dollars the global economy demands.

Continued stability in commodity prices, or even a modest upward drift to their year-beginning levels – gold at around $275 per ounce and a Commodity Research Bureau index of 230 – would be one of the most important indicators that the Fed had aligned its policies with price stability and economic growth.

Over the next several months, the economy will be searching for when it can declare a bottom and resume a healthy pace of growth.

The stock market typically finds that day about six to eight months before the low in corporate profits. In either case, better monetary policy has put us closer to that all-important turning point, which should mean better times ahead.

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