The Fed's Folly.

Monetary policy mistakes, not market failure, are behind the U.S. slump.

After agonizing to find a way of putting it delicately, here it is: What ails the market is the Federal Reserve. There is no other cause. Fear to admit this fact causes confusion. Analytical gymnastics to find alternate explanations for the market's behavior also cause confusion. Admit that the Fed made a mess and clarity takes hold.

The Fed's blunder was the belief, back in 1999-2000, that the economy was suffering from "excess demand." No such excess demand ever existed. Yet the Fed started tightening in July 1999. When the tightening ended in December 2000, demand as measured in monthly retail sales was higher and supply lower than in June 1999. The Fed's tightening did not succeed in curbing demand. It succeeded in curbing supply. Four months after supply (capacity utilization) began dropping, demand did slow down. Not Fed tightening but the shrinking of supply caused the fall in demand. Which proves that we never had an "excess demand" problem in the first place.

It gets worse. Chairman Greenspan said early this year that we are going through an "inventory adjustment" because there is now "excess supply." Hello? How did we switch from excess demand to excess supply? The daily reading of corporate press releases this past winter does not suggest, "inventory adjustment." It suggests that people are locking up and heading for the golf course--driven away by the confused policy environment. Presumably, they would return Once the Fed got it right.

In trying to fathom exactly when the Fed switched from the "excess demand" to the "excess supply" rationalization, we took a second look at the published Federal Open Market Committee (FOMC) minutes. To our surprise, we noticed that the FOMC discussions contained a judgment that the economy began producing below "full potential" around July. Producing below "full potential," in our humble understanding, denotes weak supply. This FOMC judgment was repeated at the August, October, November, and December minutes. Yet each time, the Fed decided to keep the tight interest rates--causing a further weakening of supply, a further drop below "full potential."

Until December 19, 2000, the Fed was complacently watching supply drop. Then, with the new year, it flipped out about declining demand and began emergency rate cuts. With January retail sales at $206.5 billion, it claimed that the economy's problem was a lack of "confidence" causing "weak" demand. How can it be that the January $206.5 billion was "weak demand" and the $185.6 billion of June 1999 was "excess demand?" How is it that the June 2000 capacity utilization level of 82.7 percent was below "full potential" and the 81 percent level of June 1999 was "overheating?"

In 1999, growing supply was dragging demand upward and the Fed was imagining "excess demand" In 2001, plunging supply was pulling demand down and the Fed was imagining "excess supply." When lagging demand was trying to catch up with supply, the Fed called it "excess demand." When shrinking supply then depressed demand, the Fed called it "excess supply." You get it: Lagging demand = excess demand, shrinking supply = excess supply.

Not to belabor the point: The Fed was wrong in its 1999 "excess demand" judgment. It was wrong in its 2001 "excess supply" and "inventory adjustment" judgment. The two errors are a seamless continuity. In 1999, the Fed failed to see that the natural speed limit of the economy is 4.5 to 5 percent growth, and therefore mistook the economy's behavior as "excess demand." In 2001, when the consequences of that error slapped it in the face, the Fed, for reasons of institutional dignity, rejected the economy's rebuke and instead offered the rationale of "excess supply." The implication of this posturing is that the Fed can do no wrong. You see, it is the economy that keeps getting it wrong--first with "excess demand," then with "excess supply."

The Fed has attempted to deny a major policy failure by conjuring up a nonexistent "market failure."

As a consequence, we are in crisis of global import. Until now, only the Bank of Japan and the European Central Bank were in denial of the imminent danger of global deflation. Now the U.S. Federal Reserve is also in denial. This is a situation that I would have preferred not to write about if I could have avoided it. I could not avoid it. Right now, nothing is more important for strategic planning than the fact that the Fed has "lost it." The market has been nervous and confused, and it would love to believe that the Fed is in possession of the clarity that the market itself lacks. Alas, this has not been the case. The sooner the market comes to terms with this fact, the sooner it will dissolve its confusion, and the sooner it will regain its nerve.

Criton M. Zoakos is President of Leto Research, Inc., an economic research firm in Ft. Lee, NJ.