Slow Economy: Bush Stagnation or Fed's?

WHEN Business Week magazine surveyed 20 economists in June for their views on the United States economy, Lacy Hunt was the most pessimistic of them all. He said national output would grow at a real 1.3 percent annual rate in the second quarter, well below everyone else. His forecast nearly hit the bull's-eye. The Commerce Department last week estimated a 1.4 percent growth rate in gross domestic product (GDP).

Dr. Hunt, chief economist in the US for the HongkongBank Group, remains gloomy. He predicts growth at around a 1 percent rate in this second half of the year.

"It won't do [President] Bush much good," he says.

That's probably why Treasury Secretary Nicholas Brady fired a shot across the bow of the Federal Reserve in an interview with the Wall Street Journal earlier this week. He called for a review of Congressional proposals to alter the Fed to bring its "deliberations closer to the actual circumstances in the economy."

It seems unlikely in an election year that either Congress or the administration will really want to change the Fed system. The Fed and its political independence are sacred cows to the financial community. And so Mr. Brady said he didn't want to change "the basic theory of Fed independence."

Economic studies have shown that nations with independent central banks generally have lower inflation rates than those countries with central banks controlled by the government in power.

What especially bugged Brady was that a measure of the nation's money supply known as M2 that includes currency, checking accounts, money market funds, and some certificates of deposit, has been shrinking since February. "You cannot have satisfactory growth in the economy with a negative money supply," he told the Journal.

Hunt agrees. The level of real M2 (after taking out inflation) is almost as low as seven years ago, he notes. "The problem is that the Fed continues to insist on pegging the Federal Funds rate [the interest rate commercial banks charge on overnight loans to each other] too high in relation to underlying economic equilibrium."

Hunt would rather see the Fed target growth in bank reserves.

Economists argue heatedly over monetary issues that must seem arcane to most people. Yet the M2 question is considered so important that Fed chairman Alan Greenspan devoted around half of the written part of his testimony before Congress July 21 to an attempt to explain the slow growth of this money measure. He called it "aberrant monetary behavior."

But Hunt and some other economists say that the Fed has been derelict in not lowering interest rates sufficiently to have M2 growing within its own target range of 2.5 to 6.5 percent.

"I am just amazed at the Fed," says Paul Kasriel, an economist with the Northern Trust Company in Chicago. Other factors affect the economy than money, he says. These include exports, fiscal affairs, and consumer confidence. But the Fed is "responsible" for supplying the economy with the money it needs to expand.

Hunt describes as "naive" one of Mr. Greenspan's explanations for slow M2 growth - that money has moved out of the banking system into bond funds. When investors buy shares in a bond fund, that fund uses the money to buy bonds and the bond sellers put their money back into the banking system, Hunt notes.

The Fed is counting on relatively fast growth of a narrower measure of money, M1, that includes currency and checking accounts, to lift the economy out of its stagnation.

A new study by economist Steven Russell at the Federal Reserve Bank of St. Louis, however, found that M2 has been the better predictor of the economy in five time periods (including the present one, not yet complete) when the growth rates of M1 and M2 diverged sharply. Indeed, M2 was better in predicting nominal GDP the year after the divergence in four out of the four completed periods (1962-63, 1971-72, 1975-77, 1985-1987).

Mr. Russell says it is possible that institutional changes in banking since the earlier four periods have made M2 wrong this time. But he offered no evidence of such significant changes.

If Hunt's forecast is right, the Democrats will talk a great deal in the months before the November election of the "Bush stagnation" in the economy for the last few years. More accurate would be the "Fed stagnation."

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