Why the Fed Needs to Slash Interest Rates


Scott Grannis was worried about deflation before worrying about deflation was cool.

Early last summer, while most economists were focused on the idea that the U.S. economy might be growing too fast--and that higher inflation was just around the corner--Grannis was insisting that his peers had it dead wrong.

“The evidence is getting stronger every day that growth does not cause inflation the way everyone fears,” Grannis, chief economist at Pasadena-based Western Asset Management, wrote to clients on June 13.

And this, on June 27: “The inflation/price picture is awesome. Lots of prices are actually falling. Is the Mother of all Bond Rallies just around the corner?”


And this, on July 3: “Deflation may be the new order of the day.”

Fast-forward to the present. Last Friday’s U.S. employment report for December showed another surge in jobs created last month (327,000). A total of 3.2 million jobs were created in 1997, amid robust economic growth.

Yet the government’s index of wholesale prices actually declined by 1.2%. In other words, we had deflation, not inflation.

Now, of course, everyone is talking about deflation--even if most people aren’t quite sure what it means. What many people do know, however, is that it’s not necessarily a good thing.

Deflation, so far, means that interest rates can fall (and have), which is great for people who own bonds or want to refinance their mortgages. But the message from crumbling global stock markets last week--the Dow Jones industrial average slumped 4.8% to 7,580.42, amid more signs that East Asia’s economy is sinking--was that deflation isn’t welcome if it forces companies en masse to slash product prices and destroy their profit margins in a bid to compete with desperate foreign rivals.

Suddenly, anyone old enough to remember the deflation of the 1930s, during the Great Depression, is in demand. “What was it like?” reporters want to know.

At age 48, Scott Grannis obviously wasn’t around to chronicle the last major deflation wave. But he thinks he knows enough economic history to warn that the Federal Reserve Board risks making the same mistake now that it made at the start of the Depression: keeping money too tight in the economy for too long, turning prosperity into ruin by allowing a deep deflationary spiral to begin and then accelerate.



Fed Chairman Alan Greenspan, in fact, warned of the dangers of a severe deflation cycle in a speech a week ago. He indicated that he would be more concerned about a sustained deflationary decline in prices of assets such as stocks and real estate--the Japanese experience of the 1990s--than in prices of goods and services.

But one would probably accompany the other if the root cause is collapsing consumer and business confidence and the thinking by a majority of people that there is no reason to buy things today because prices will only get cheaper.

Grannis, while pleased that Greenspan raised the “D” word, argues that the Fed should stop talking conceptually about deflation and do something to make sure it doesn’t occur on a broad scale.

That something, Grannis says, would be a major cut in short-term interest rates--a full percentage- point drop in the Fed’s benchmark federal funds rate, now at 5.5%.

“They need to make a huge statement” about keeping the economy advancing, and deflation contained, via cheaper credit, Grannis argues.

Grannis, however, does not appear to have Greenspan’s ear. Grannis’ firm, Western Asset, has 150 institutional clients and manages about $36 billion in bonds, but it isn’t a well-known name on Wall Street.


And Grannis admits that his ideas run counter to the Fed’s cherished models for predicting the economy and inflation trends--models that hold that full employment is bad and that fast economic growth causes inflation.

That’s the Fed’s problem, Grannis says. “They’re using the wrong models.” (Greenspan has at least mused about this possibility.)


Grannis’ interest in economics began to blossom when he was living in Argentina in the late 1970s, in the days of South American hyperinflation, when prices rose not 7% in a year, but 7% in a month or less. “You can’t live through that without becoming very interested in money” and economics, Grannis says.

Returning with his wife to the United States, Grannis received his MBA degree from Claremont Graduate School in 1980 and went to work for what was then the Claremont Economics Institute.

At the time, Claremont was an advisor to the Reagan administration, along with the “supply-side” economics camp. The supply-siders, led by economist Arthur Laffer, forecast a rosy scenario for the U.S. economy in the 1980s. Huge tax cuts, they said, would stimulate demand and spur growth.

At the same time, Grannis and his Claremont cohorts forecast that inflation would decline sharply and with it interest rates, even as the economy expanded--a notion that seemed absurd to many people in 1981, with inflation raging and interest rates still near record highs.


As it turned out, Grannis and his Claremont peers were correct about inflation and rates, even though by the late 1980s supply-side economics had been discredited amid soaring federal budget deficits.

Grannis remains unapologetic about supply-side economics. The deficits of the 1980s, he notes, did not ruin the economy. And the proof that supply-side worked, he says, is that the economy continued to expand in the 1990s, to its current extraordinarily healthy status.

If supply-side was a house of cards, Grannis asks, “why didn’t the economy go back to where it was,” or worse?

In the 1990s, as Western Asset’s chief economist, Grannis has been guided by the same “monetarist” view of inflation he has held all along--i.e., that too much money chasing too few goods causes inflation, not strong economic growth by itself.

Growth, in fact, is good for maintaining low inflation, he says, because it means that industrial capacity expands and more goods and services are available to compete for consumers’ dollars.

“Since when is inflation caused by too many people working?” Grannis asks rhetorically, a question that more economists have come to ask in the ‘90s.


But Grannis says his view of the traditional cause of higher inflation--a too-easy Fed, pumping excess money into the financial system--has been revised somewhat.


What also matters, he argues, is how much demand there is for money.

“The Fed can control the supply of money, but they also need to know what the demand is,” Grannis says. If significant demand for money isn’t accommodated, then the Fed may be tightening credit even when it otherwise appears to be maintaining a steady policy by holding interest rates level, he says.

That is where Grannis believes the Fed has missed the boat over the last year: He argues that the Fed has allowed two de facto credit-tightening moves since April even though its key rate has remained at 5.5%:

* As the consumer inflation rate declined to under 2% last year, the Fed’s level interest rate policy in effect raised real (after-inflation) interest rates in the economy--a credit-tightening move by any other name, Grannis says.

* The dollar’s surging value against most currencies last year made business tougher for U.S. companies versus their foreign competitors, putting a drag on the economy--another effective credit-tightening, Grannis argues.

But were those “stealth” tightenings exactly what was needed to slow a too-hot economy? The “old model” may say so, but it’s wrong, Grannis says.



The Fed, he said, should have accommodated the demand for dollars that was evident in the economy’s underlying strength, and in the strength of the dollar.

The dollar, he says, was merely indicating that investors truly believed that inflation had been vanquished, and thus that it made more sense than ever to invest in financial assets such as stocks and bonds--and not, for example, in inflation hedges such as gold.

While many people keep looking over their shoulder for 1970s-style inflation, Grannis says, markets have been saying that inflation finally has been quashed.

Now the greater risk is deflation, Grannis says: If the Fed doesn’t pump liquidity into the system, fortifying demand for all of the goods and services that the economic expansion of the 1990s wants to provide, the risk could become too few dollars chasing too many goods.

There is only one intelligent move for the Fed, he says: Greenspan must cut short-term interest rates quickly--and sharply.

There still is plenty of time for the Fed to stop a deflationary spiral, says Grannis. But if the Fed waits too long, the risk is that it will fall behind the curve, he says: If a deflationary mind-set takes over in the global economy and people fear broadly falling prices, that will be a far tougher tide for central banks to turn back.


Does Grannis believe the Fed is preparing for a rate cut? Yes.

And if the Fed balks?

“Then Greenspan is a fool,” he says.


Tom Petruno can be reached at