* Additional monetary and fiscal policy stimulus is needed in order to offset the contractionary forces unleashed by lower equity prices and a more uncertain, risky economic environment.
* The federal funds rate needs to be reduced significantly further in order to make financial conditions more accommodative.
* Fiscal policy should also be made more accommodative in order to facilitate an upward adjustment in the household saving rate without this shift requiring a large reduction in consumer spending.
* Personal income tax cuts and increased government spending would provide the strongest impetus to economic activity. Reductions in the capital gains tax rate would likely have negligible effects on aggregate economic activity over the next year.
Monetary and Fiscal Policy Should Be Eased Further
We strongly believe that monetary and fiscal policy should be made more accommodative. This reflects several factors:
1. Powerful contractionary forces have been unleashed. In particular, the terrorist events of last week have ratcheted up the risks in the economic environment for both the household and corporate sectors. These events will hurt business and consumer confidence and lead to further reductions in business investment and consumer spending. The vulnerability of both sectors is high because the desired shift towards higher saving and greater liquidity is occurring at a time when household and corporate balance sheets have become more leveraged and the household sector has dramatically cut its saving rate over the past decade.
2. The impact of an easier monetary policy has been blunted up to now by a weaker equity market, a stronger dollar, and a steeper yield curve. As a result, financial conditions as measured by the Goldman Sachs Financial Conditions Index (GSFCI), are virtually unchanged from where they were at the beginning of the year. Thus, those expecting monetary policy stimulus to provide much near-term lift to economic activity are likely to be disappointed. This does not mean that monetary policy no longer works -- just that the monetary policy lever needs to be pushed more forcefully than in the past. With this in mind, we would expect the federal funds rate to trough at around 2% by early next year, although clearly there is much uncertainty surrounding this particular forecast. We also would expect short-rate interest rates to stay low for an extended period of time. Although the growth trajectory is now likely to be more V-shaped than before, we do not anticipate sufficient strength during the second half of 2002 to push down the unemployment rate. A decline in the unemployment rate will probably prove to be a necessary condition for anything more than a token tightening of monetary policy.
3. More fiscal policy stimulus is needed. Fiscal stimulus is necessary so that the desired adjustment in saving behavior can occur without necessitating a large and sustained pullback in spending.
In terms of fiscal stimulus, we would favor measures that put more money in the pockets of the average consumer and increased government spending to beef up security and to rebuild the damaged New York infrastructure and the Pentagon. In terms of tax cuts, this implies income tax cuts that are oriented mainly toward moderate-income households. This could be accomplished via a tax rebate of the 2001 tax liability in early 2002 or by moving up some of the scheduled marginal income tax rate reductions that were part of this year's tax cut legislation.
A reduction in the capital gains tax rate--an idea floated by some Congressional Republicans--is less attractive for four reasons:
1. It would not provide much lift to economic activity. The fact is that business investment is relatively insensitive to the cost of capital. Moreover, the cost of capital can be more easily addressed directly via monetary policy.
2. It would disproportionately favor high-income households, so that any tax saving would probably be saved more than spent.
3. In the short run, it could lead to equity market weakness as investors rushed to take advantage of the lower capital gains tax rate. Over the longer-run, a lower capital gains tax rate would tend to be slightly positive for equity prices. The effect would be mild, however, given that the effective rate on capital gains is already far below the top statutory rate of 20%.
4. By widening the gap between ordinary income tax rates and capital gains tax rates, such a change could encourage non- economic behavior designed to convert ordinary income into capital gains income. Such efforts generate a dead-weight loss to society.
Reportedly, the White House is preparing a new fiscal policy proposal. The details of any proposal should certainly be debated in terms of composition, size, and timing. But the notion of further fiscal stimulus should not be resisted. The economy needs support and the fiscal policy lever is one important mechanism that can be used to provide it.
Bill Dudley