Insight Line—January 28, 2008

When it comes to influencing economic activity through policy making, the Federal Reserve Open Market Committee (FOMC) is not the only player in the game. You see, the federal government can also implement policy actions designed to improve or forestall economic growth. However, the government’s tool is not interest rates, but adjustments to existing federal spending and/or taxation levels.

For decades, Americans have looked to policy makers at the FOMC to steer the economy on the right course. The FOMC raised interest rates when inflation threatened and lowered rates when growth stalled. And because rate changes can be implemented quickly and without partisan political debate, monetary policy moves generally appealed to investors as the ideal tool for whatever economic job was at hand.

This confidence in the FOMC is largely deserved. However, there are certain periods during which the track record of the FOMC is somewhat questionable. Two instances that come to mind—with the benefit of hindsight and a consensus amongst economists—are the too-restrictive policy moves in mid-2000 and the too-accommodative policies pursued in mid-2003. Nonetheless, central bank monetary policies by and large operate on the plus side of history’s ledger.

But if monetary policy is not infallible, what should we make of policy actions undertaken by the FOMC in 2007, and to what extent will these actions contribute to or detract from the inevitability of a recession in 2008? After all, no two points in time are identical, especially when dealing with the complex and dynamic nature of the U.S. economy. Nor are FOMC policy makers incapable of learning from history’s lessons. Quite the contrary, in fact, as recent policy actions appear to have roots in lessons learned from the FOMC’s responses to the bankruptcy of the Penn Central Corporation in 1970, the stock market crash of October 1987, and the terrorist attacks of September 11, 2001.¹ That said, I suggest it is reasonable to ask what assurance do investors have that the FOMC’s measured monetary policy actions are all that is needed to resolve the current financial dislocations, which originated in the U.S. mortgage market and now reverberate around the globe?

The answer, as I see it, is that there is no assurance of the FOMC’s success, thus enabling the Bush administration to now step to the forefront with policy prescriptions of its own.

The White House’s proposed fiscal stimulus package calls for multiple tax relief measures in an effort to spur consumer spending and business investment.

One course of action—temporary tax rebates for taxpayers—is based on theories championed decades ago by the economist John Maynard Keynes that invoke changes in government revenue patterns as an effective approach to addressing broad-based economic goals. Recent examples include the unfunded tax rebates of 1975, 2001 and 2003.

The other course of action—tax rate reductions for businesses and individuals—addresses incentive-based or supply side of macro economic forces. This approach, though not new, gained renewed popularity in 1981 when quarterbacked by economist Arthur Laffer during the Regan administration. The 2001 and 2003 reduction in income and capital gains rates are perhaps the best-known recent examples, however the Kennedy administration used such an approach with great success back in 1962. Strikingly, the Bush administration seems willing to employ both theories: the belt and suspenders approach, if you will.

All of which, as I see it, sets in motion a combination of monetary and fiscal policy moves that greatly improves the odds of success for either approach. In essence, the fix is in. Unfortunately, if history is to be any guide, for today’s anxious investor such success will not come overnight.

¹ Mishkin, Frederic S., “Financial Instability and the Federal Reserve as a Liquidity Provider,” speech at the Museum of American Finance Commemoration of the Panic of 1907, New York, New York, October 26, 2007

This material has been prepared using sources of information generally believed to be reliable. No representation can be made as to its accuracy. The forecasts and opinions in this piece are not necessarily those of Van Kampen, and may not actually come to pass. Information in this report does not pertain to any Van Kampen product and is not a solicitation for any product.