NCPA - National Center for Policy Analysis

Growth Is On The Way

August 20, 2001

We may be closer to the bottom of the slowdown than most people think, according to a recent analysis by economist Charles Kadlec of J. & W. Seligman in New York.

Kadlec's key point is that monetary policy has not been as expansive as the Fed and financial markets think. Kadlec notes that the Fed does not control all interest rates, just the fed funds rate -- the interest rate banks charge each other, representing the basic cost of the funds banks lend out.

The Fed funds rate was 6.5 percent a year ago, and the Fed has lowered it in steps since January 2001 to 3.5 percent. In theory, lower interest rates lead to monetary expansion because they lower the cost of holding cash, and because the Fed must add liquidity to the financial system in order to achieve its interest rate target.

  • But the average fed funds rate in January was almost 6 percent, well above many market interest rates, while the Treasury's 30-year bond was just 5.5 percent, and all bonds with shorter maturities were even lower (see figure).
  • This meant that banks could not borrow fed funds and relend them at a profit; as a result, monetary policy was impotent.
  • But by May the situation had turned around, as the average fed funds rate fell to 4.2 percent -- lower than the Treasury's 2-year note rate.

At this point monetary policy finally became expansive, and the money supply began growing.

Kadlec further notes that the economic slowdown is narrowly concentrated -- falling inventories and investment subtracted 2.7 percent from 2nd quarter GDP growth. Thus, if investment and inventories just stop falling, growth could rebound to more than 3 percent quickly. When firms begin to expand inventories and investment, growth will be even faster.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, August 20, 2001; see Charles Kadlec and Mike Aguilar (J. & W. Seligman & Co. Incorporated), "The Tide May Be Turning," Economic Commentary, August 6, 2001.


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