The Fed and Its Skeptics By Jim Griffin Special to TheStreet.com 5/20/01 10:00 AM ET

It must have been a cautious demolition specialist who set the timer on last Tuesday's FOMC policy move: The market reaction took place the day after the fuse was lit.

A useful question to ask yourself now, regarding not only the market as a whole but also yourself personally, is whether it's wiser to have faith in the Fed today, or to remain a doubting Thomas. The market's answer will, of course, be determining, so this is a good time to check your alignment with it.

Last week's easing move was the fifth in 2001, and there were hints and nudges of more to come in the press release that announced this latest policy decision. It is no longer possible for a fair-minded analyst to doubt the Fed's commitment: It has eased by 250 basis points in little more than four months. For perspective, it took 23 months for the Fed to cut its target rate by 500 basis points between October 1990 and September 1992 against the headwinds of huge real estate loan losses and banking system capital constraints.

Still, skeptics argue that our central bankers have been dilatory. Slow to start, haven't eased enough yet, behind the curve -- the professional kvetchers and CNBC talking heads (is that redundant?) seem to believe that the Fed never gets it right. Last year it tightened too much. This year it hasn't eased enough. What sort of gripe, I wonder, is in store for next year?

The Fed's communication of its point of view has been as direct as its policy has been decisive. It thinks, or hopes, that recession will be avoided, but that it's a close call and the risks are to the downside. The business correction has been exceptionally abrupt; its very quickness creates the possibility of downward momentum that might have, or might yet, run out of control. But the latest evidence suggests that the production cuts that already have taken place have been sufficient to get inventories roughly back into line with sales, and that if nothing further goes wrong, it is possible to foresee the end of the weakening trend in business activity, to be followed by stabilization and recovery. The key is consumption spending and critical to that is wage and salary income, job security and consumer confidence. In this setting, the historically aggressive easing that has taken place so far has been intended both to cushion the momentum of production cutbacks and shore up business and consumer confidence.

Private forecasters, and the market, apparently remain skeptical of the Fed's efficacy, because they can't be in doubt about its intentions -- not if they're paying attention. The rebound/recovery scenario must be a risk factor rather than a base case for the mainstream. Such skepticism has prevailed at least since last year's fourth quarter, before the Fed's first easing initiative, and it seems to be giving way only grudgingly now as the easing moves pile up.

So is it better today to have faith, or to remain a doubting Thomas? Up until this point, the nod goes to the skeptics; they have not been disadvantaged by remaining overweight in cash, the skeptic's natural asset of choice. It's one thing to look askance at the first easing move, but there are quite different implications to skepticism following the fifth move. It suggests an inability to distinguish between the U.S. Federal Reserve System, on the one hand, and the Bank of Japan, on the other.

For investment horizons of the next six to 12 months, cash may make sense for those who confuse the Fed with the B of J. For investors who can distinguish between a central bank that wields its simple tools energetically and a pettifogging bureaucracy of placeholders, low-yielding cash looks more and more like a wasting asset.

The Fed is not the whole case for taking a leap of faith. Wage and salary incomes are holding up reasonably well even as the squeaky tightness of the labor market relaxes. It is too early to be sure, but the latest readings suggest that consumer confidence may have stopped retreating. The market's focus on the miserable shrinkage of one form of income, profit, has distracted the eye from the fact that labor incomes have maintained their pre-existing trend. That is a profoundly important argument for aligning one's own view with the fragile confidence the Fed expresses regarding the outlook.

Then there is the stimulus of tax cuts yet to come and the effects of the capital-deepening and productivity-enhancing investments that have been put in place, perhaps too eagerly, in the recent past. These investments have served to increase the operating leverage of the U.S. corporate sector -- when revenues change a little, profits change by quite a lot and in the same direction. It is not difficult to imagine that next year analysts will be scrambling to raise their earnings estimates in the wake of a surprising rebound from this year's numbers.

Nor is it difficult to imagine the CNBC talking heads criticizing the Fed for being too slow to recognize that inflation, like Dracula, is not really dead, and for having eased too much in 2001. Wrong in 2000, wrong in 2001 and wrong again in 2002 can't they ever get it right?

As I hope you can tell, I'm skeptical of the Fed's skeptics. The bottom line, as I've argued in this space in recent weeks, is that changes in the structure of the economy and the regulation of financial markets render those capital markets both more volatile and more important to the formulation of monetary policy. You have not heard Fed heads talk of pre-emptive policy in five or six years. They recognize now that calling the turns is probably impossible, and that quick and aggressive reaction is the best tactic that realistically can be executed. The recent record of active, aggressive, reversible policy moves squares empirically with this deduction.

The critical point is that, in the current and prospective setting, U.S. monetary policy officials may, more often than in the past, be liable to a charge of being "wrong"; you can safely be skeptical of their omniscience. But when it comes to the central bank's effectiveness in achieving its aims, it's wise to take the leap of faith.

Don't fight the market. Don't fight the Fed. So far this year, you have been forced to choose sides, because the market was fighting the Fed. But for the rest of the year, if you're spoiling for trouble, you are likely to have to fight them both. That's the sort of heroism that leads to posthumous awards.

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