Déjà Vu: The Fed's Interest Rate Dilemma

By BRIAN WESBURY

Despite record passenger traffic, airlines are bleeding cash and going bankrupt. Food riots have cropped up around the world, Canada is paying farmers to kill pigs because feed costs too much, and rice, it seems, is in very short supply.

While ethanol subsidies have created havoc, they don't explain everything – like huge increases in precious metals prices, the sharp decline in the value of the dollar, or record-high fuel prices.

What's missing in most analysis is the impact of inflationary monetary policy. Since 2001, and especially since September 2007 – when the Fed started cutting rates in response to credit market issues – excessively easy monetary policy has driven oil and other commodity prices through the roof.

The good news is we've been here before, and we know – well, at least 1980s Fed Chairman Paul Volcker knows – how to get out of this mess. Loose money in the 1960s and 1970s drove up the price of everything. A barrel of oil, which sold for $2.92 in 1965, rose to $40 in 1980. Most people believed that rising commodity prices indicated that the world was running out of resources. The Club of Rome predicted global ruin, and then President Jimmy Carter said that "peak oil" was right around the corner.

Oklahoma-based Penn Square Bank handed out oil loans freely, and sold off pieces of its loans in packages called "participations." Seafirst Bank in Seattle and Continental Bank in Chicago were two good customers. These banks thought oil prices would remain elevated and paid a huge price for their mistake.

Today, Bear Stearns, Countrywide and subprime lending are a repeat of Penn Square, Continental and oil loans. Bad decision making, based on a money-induced mirage, is the culprit. We are not running out of food or natural resources; this is an entirely man-made disaster caused by the Fed opening wide the monetary floodgates.

Money is the ultimate commodity because all prices have only money in common. And it is the only thing that a central bank directly controls. Unfortunately, because of globalization and financial-market innovation, money itself has become hard to measure and useless as a forecasting tool. So analysts use interest rates.

The "natural rate of interest" is the theoretical interest rate at which monetary policy does not artificially boost the economy, nor hold it back. It is also the rate at which money is neutral on inflation. There have been many attempts at measuring this. Some economists look at real interest rates. Others use the Taylor Rule, which includes a target rate for inflation and real growth.

And while these methods are helpful, they rely on estimates. I devised a much simpler system back in 1993, based on actual economic data, that has proven extremely useful. It predicted the sharp increase in long-term interest rates in 1994; it also predicted the recession of 2001, the deflation of the early 2000s, and the inflation of recent years.

This model shows that a neutral federal funds rate should be roughly equal to nominal GDP growth. Nominal GDP growth (real growth plus inflation) measures total spending in the economy, or to put it another way, it reflects the average growth rate for all companies in the economy.

If interest rates are pushed well below nominal GDP growth, money is too easy and it encourages leverage. If interest rates are pulled above nominal GDP, money is too tight, and average companies cannot overcome borrowing costs.

Between 1960 and 1979, the federal funds rate averaged 5.6% and nominal GDP growth averaged 8.4%. With the funds rate 280 basis points below GDP growth, monetary policy was highly accommodative. The result: a falling dollar, rising commodity prices and fears that resources were being used up.

In 1980, then Fed Chairman Volcker lifted the fed funds rate significantly above GDP growth and held it there long enough to end inflation. This policy instigated a steep decline in oil prices, and drove a stake through the heart of stagflation.

Oil and inflation stayed low in the 1980s and '90s, when the Fed held the fed funds rate 74 basis points above GDP growth on average. By 1999, with oil prices still low, the Economist magazine wrote that the world was "drowning in oil."

Low inflation turned to deflation in 1999 and 2000, when the Fed mistakenly pushed the funds rate above nominal GDP growth again. This deflation spooked the Fed and led to a radical reduction in interest rates. Since then, the fed funds rate has been well below GDP growth – an average of 210 basis points – the most accommodative six years of monetary policy since the 1970s. No wonder inflation is on the rise and commodity prices are setting new records.

The Fed lifted the funds rate from 1% to 5.25% between 2004 and 2006, but monetary policy was never tight because the rate never went above nominal GDP. This suggests that housing market problems were not caused by tight money in 2006-07, but by excessive investment during the super-easy money of the years before.

Nonetheless, the Fed opened up the old playbook and cut rates aggressively when subprime loans blew up. This cemented higher inflation into place, crushed the dollar, pushed commodity prices up sharply, and created major problems in the energy, airline and agricultural marketplaces. And just like the 1970s, it is now popular to argue that the world is running out of resources again.

The answer to all of this is for the Fed to lift rates back to their natural rate, which is somewhere north of 5%. Tax-rate reductions and interest-rate hikes cured the world of its ills in the early 1980s. They can do so again.

Getting to Know John McCain

By KARL ROVE

It came to me while I was having dinner with Doris Day. No, not that Doris Day. The Doris Day who is married to Col. Bud Day, Congressional Medal of Honor recipient, fighter pilot, Vietnam POW and roommate of John McCain at the Hanoi Hilton.

As we ate near the Days' home in Florida recently, I heard things about Sen. McCain that were deeply moving and politically troubling. Moving because they told me things about him the American people need to know. And troubling because it is clear that Mr. McCain is one of the most private individuals to run for president in history.

AP

Col. (Ret.) Bud Day with John McCain at a campaign stop in Pensacola, Fla., in January.

When it comes to choosing a president, the American people want to know more about a candidate than policy positions. They want to know about character, the values ingrained in his heart. For Mr. McCain, that means they will want to know more about him personally than he has been willing to reveal.

Mr. Day relayed to me one of the stories Americans should hear. It involves what happened to him after escaping from a North Vietnamese prison during the war. When he was recaptured, a Vietnamese captor broke his arm and said, "I told you I would make you a cripple."

The break was designed to shatter Mr. Day's will. He had survived in prison on the hope that one day he would return to the United States and be able to fly again. To kill that hope, the Vietnamese left part of a bone sticking out of his arm, and put him in a misshapen cast. This was done so that the arm would heal at "a goofy angle," as Mr. Day explained. Had it done so, he never would have flown again.

But it didn't heal that way because of John McCain. Risking severe punishment, Messrs. McCain and Day collected pieces of bamboo in the prison courtyard to use as a splint. Mr. McCain put Mr. Day on the floor of their cell and, using his foot, jerked the broken bone into place. Then, using strips from the bandage on his own wounded leg and the bamboo, he put Mr. Day's splint in place.

Years later, Air Force surgeons examined Mr. Day and complimented the treatment he'd gotten from his captors. Mr. Day corrected them. It was Dr. McCain who deserved the credit. Mr. Day went on to fly again.

Another story I heard over dinner with the Days involved Mr. McCain serving as one of the three chaplains for his fellow prisoners. At one point, after being shuttled among different prisons, Mr. Day had found himself as the most senior officer at the Hanoi Hilton. So he tapped Mr. McCain to help administer religious services to the other prisoners.

Today, Mr. Day, a very active 83, still vividly recalls Mr. McCain's sermons. "He remembered the Episcopal liturgy," Mr. Day says, "and sounded like a bona fide preacher." One of Mr. McCain's first sermons took as its text Luke 20:25 and Matthew 22:21, "render unto Caesar what is Caesar's and unto God what is God's." Mr. McCain said he and his fellow prisoners shouldn't ask God to free them, but to help them become the best people they could be while serving as POWs. It was Caesar who put them in prison and Caesar who would get them out. Their task was to act with honor.

Another McCain story, somewhat better known, is about the Vietnamese practice of torturing him by tying his head between his ankles with his arms behind him, and then leaving him for hours. The torture so badly busted up his shoulders that to this day Mr. McCain can't raise his arms over his head.

One night, a Vietnamese guard loosened his bonds, returning at the end of his watch to tighten them again so no one would notice. Shortly after, on Christmas Day, the same guard stood beside Mr. McCain in the prison yard and drew a cross in the sand before erasing it. Mr. McCain later said that when he returned to Vietnam for the first time after the war, the only person he really wanted to meet was that guard.

Mr. Day recalls with pride Mr. McCain stubbornly refusing to accept special treatment or curry favor to be released early, even when gravely ill. Mr. McCain knew the Vietnamese wanted the propaganda victory of the son and grandson of Navy admirals accepting special treatment. "He wasn't corruptible then," Mr. Day says, "and he's not corruptible today."

The stories told to me by the Days involve more than wartime valor.

For example, in 1991 Cindy McCain was visiting Mother Teresa's orphanage in Bangladesh when a dying infant was thrust into her hands. The orphanage could not provide the medical care needed to save her life, so Mrs. McCain brought the child home to America with her. She was met at the airport by her husband, who asked what all this was about.

Mrs. McCain replied that the child desperately needed surgery and years of rehabilitation. "I hope she can stay with us," she told her husband. Mr. McCain agreed. Today that child is their teenage daughter Bridget.

I was aware of this story. What I did not know, and what I learned from Doris, is that there was a second infant Mrs. McCain brought back. She ended up being adopted by a young McCain aide and his wife.

"We were called at midnight by Cindy," Wes Gullett remembers, and "five days later we met our new daughter Nicki at the L.A. airport wearing the only clothing Cindy could find on the trip back, a 7-Up T-shirt she bought in the Bangkok airport." Today, Nicki is a high school sophomore. Mr. Gullett told me, "I never saw a hospital bill" for her care.

A few, but not many, of the stories told to me by the Days have been written about, such as in Robert Timberg's 1996 book "A Nightingale's Song." But Mr. McCain rarely refers to them on the campaign trail. There is something admirable in his reticence, but he needs to overcome it.

Private people like Mr. McCain are rare in politics for a reason. Candidates who are uncomfortable sharing their interior lives limit their appeal. But if Mr. McCain is to win the election this fall, he has to open up.

Americans need to know about his vision for the nation's future, especially his policy positions and domestic reforms. They also need to learn about the moments in his life that shaped him. Mr. McCain cannot make this a biography-only campaign – but he can't afford to make it a biography-free campaign either. Unless he opens up more, many voters will never know the experiences of his life that show his character, integrity and essential decency.

These qualities mattered in America's first president and will matter as Americans decide on their 44th president.

The Dangers of Samuelson's Economic Method

by Robert Higgs

Paul A. Samuelson (May 15, 1915–)

We are advised against speaking ill of the dead. In this regard, I am safe, I suppose, because Paul A. Samuelson, whom I intend to criticize, remains alive, although he will soon be 93 years old and therefore cannot be long for this world. When I was first learning economics, in the 1960s, Samuelson was held up by my teachers as the greatest living economist — a genius, they used to say. In the course of my undergraduate and graduate training, I was given no reason to doubt that assessment.

Indeed, a memorably painful part of my graduate education consisted of my attempts to read and understand Samuelson's landmark book Foundations of Economic Analysis (1947), a treatise in mathematical economic theory, patterned after classical thermodynamics, that set the tone for much of what the cleverest mainstream economists would do for decades to come. The protocol became: build a mathematical model of abstract actors engaged in constrained maximization or minimization of an objective function; prove that the model has a stable equilibrium; show how the model's equilibrium conditions change when its parameters are changed (the so-called method of comparative statics).

I also had the pleasure — if that is the right word — of meeting Samuelson in person once, early in 1968, when I visited the economics department at MIT as a candidate for a job there. At a luncheon seminar with Samuelson and several other members of the department, I enjoyed — if that is the right word — the famous Samuelsonian wit and arrogance. Although the members of the group bantered and joked at one another's expense during the luncheon, as academics commonly do, it was clear to me that Samuelson's jokes at a colleague's expense dominated a colleague's jokes at his expense. This pecking order came as no surprise to me. I was taken aback, however, that the great man also made jokes at my expense. Of course, as an apprehensive and insecure 24 year old looking for a job, I made no jokes at anybody's expense, and certainly not at Samuelson's. Forty years later, and somewhat wiser in the often ill-mannered ways of academia, I remain disappointed that the acclaimed "greatest living economist," a man who only two years later would become the first American to receive the Nobel prize in economics, would choose to bully a mere graduate student.

Anyone who has read Samuelson's articles and books, however, knows that his arrogance often stands in prominent display. Whether or not he was the greatest living economist, he often expressed himself with the kind of Olympian condescension that strongly suggests he believed himself to be Numero Uno. I was struck by this quality most recently in reading, strange to say, his article "Economic Theory and Mathematics — An Appraisal" (American Economic Review 42 [May 1952]: 56–66). At the end of the first paragraph, Samuelson writes, "I firmly believe in the virtues of understatement and lack of pretension." Upon encountering this affirmation of authorial modesty, I nearly burst out laughing.

Although Samuelson declares that he comes "not to praise mathematics, but rather to slightly debunk its use in economics," the thrust of his article can scarcely be described as debunking. Indeed, in my view, he makes grandiose and indefensible claims on behalf of the use of mathematics in economics. I am no philosopher, but I venture to say also that he makes indefensible claims about mathematics itself — a point that I will leave for better qualified heads to judge. Samuelson's main claim is that "in deepest logic," mathematics and prose "are strictly identical" (p. 56). My not-very-highly-tutored philosophical hunch is that this claim will no longer be regarded as holding water, if it ever was so regarded. Yet, like many of Samuelson's declarations, it is expressed with the sort of absolute confidence typical of the early generations of positivists.

Human Action Scholar's Edition: $65 $54

Samuelson maintains that "[e]very science is based squarely on induction — on observation of empirical facts. … [D]eduction has the modest linguistic role of translating certain empirical hypotheses into their 'logical equivalents'" (p. 57). It seems obvious that for him, as for his legions of disciples, an a priori economic theory, such as the praxeological theory that Ludwig von Mises expounds in Human Action (1949), does not qualify as science. Although he does not mention Mises in the article, one suspects that he might have had the great Austrian economist in mind when he wrote, "[N]o a priori empirical truths can exist in any field. If a thing has a priori irrefutable truth, it must be empty of empirical content" (p. 62). He then affirms, with characteristic haughtiness, that "at the rough and ready level that concerns the scientist in his everyday work," this view is "widely recognized by scientists in every discipline. The only exceptions are to be found in certain backwaters of economics, and I shall not here do more than point the finger of scorn at those who carry into the twentieth century ideas that were not very good even in their earlier heyday" (p. 62).

One wonders what status Samuelson would accord the Action Axiom — the statement that human beings have ends and use means in conscious attempts to attain those ends. Would he deny that it is apodictically certain? And would he also deny that it is empirically valid?

In a 1957 defense of Misesian methodology, Murray N. Rothbard notes, "Whether we consider the Action Axiom 'a priori' or 'empirical' depends on our ultimate philosophical position" ("In Defense of 'Extreme Apriorism,'" Southern Economic Journal 23 [January 1957]: 317–18). He observes that Mises, taking a Kantian view, regards the axiom as "a law of thought and therefore a categorical truth a priori to all experience" (p. 318). In contrast, Rothbard considers the axiom "a law of reality rather than a law of thought, and hence 'empirical' rather than 'a priori'" (p. 318), although he concedes that "this type of 'empiricism' is so out of step with modern empiricism that I may just as well continue to call it a priori" for the arguments at issue. He explicates the axiom by saying: "(1) it is a law of reality that is not conceivably falsifiable, and yet is empirically meaningful and true; (2) it rests on universal inner experience, and not simply on external experience, i.e., its evidence is reflective rather than physical; and (3) it is clearly a priori to complex historical events" (p. 318, footnotes omitted). Samuelson does not deign to consider these issues, opting instead for supercilious derision.

Samuelson does mention one great Austrian economist, indeed, the founder of the Austrian School himself, Carl Menger. His remarks at this point merit extended quotation. "Jevons, Walras, and Menger," he writes, "each independently arrived at the so-called 'theory of subjective value.' And … Menger did arrive at his formulation without the use of mathematics. But," he continues,

I should point out that a recent rereading of the excellent English translation of Menger's 1871 work convinces me that it is the least important of the three works cited; and that its relative neglect by modern writers was not simply the result of bad luck or scholarly negligence. I should also add that the important revolution of the 1870's had little really to do with either subjective value and utility or with marginalism; rather it consisted of the perfecting of the general relations of supply and demand. It culminated in Walrasian general equilibrium. And we are forced to agree with Schumpeter's appraisal of Walras as the greatest of theorists — not because he used mathematics, since the methods used are really quite elementary — but because of the key importance of the concept of general equilibrium itself. (p. 61)

Samuelson's evaluation, one might venture to say, has matters exactly backward. He fails to see how and why Menger's development of marginal utility and related economic theory is actually superior to the formulations of Jevons and Walras. On this question, the reader can do no better than to consult Jörg Guido Hülsmann's splendid dehomogenization of the three marginalist pioneers' views in his magnificent, recently published biography Mises, The Last Knight of Liberalism (2007, pp. 125–36).

Hülsmann quotes William Jaffé's comments, which are so apt that I will quote them again:

Menger kept too close to the real world for either the verbal or symbolic formulation of the theory; and in the real world he saw no sharply defined points of equilibrium, but rather bounded indeterminacies not only in isolated bilateral barter but also in competitive market trading. … With his attention unswervingly fixed on reality, Menger could not, and did not, abstract from the difficulties traders face in any attempt to obtain all the information required for anything like a pinpoint equilibrium determination of market prices to emerge, nor did his approach permit him to abstract from the uncertainties that veil the future, even the near future in the conscious anticipation of which most present transactions take place. (Quoted in Hülsmann, Mises, p. 135)

In this light, we see clearly that Samuelson's positivist insistence that economic science must rest on empirical facts clashes with his expressed preference for abstract, perfect-information general equilibrium, à la Jevons and Walras, in lieu of Menger's utterly realistic foundation for economic reasoning.

Nothing has done more to render modern economic theory a sterile and irrelevant exercise in autoeroticism than its practitioners' obsession with mathematical, general-equilibrium models. Not only does this focus result in the futile spinning of mental wheels by mathematical pseudoeconomists, but it has pernicious consequences for policy formulation because, as James M. Buchanan has observed, it gives rise to "the most sophisticated fallacy in economic theory, the notion that because certain relationships hold in equilibrium [in the model] the forced interferences designed to implement these relationships [in the real world] will, in fact, be desirable" (What Should Economists Do? [1979], p. 83).

Samuelson writes that although mathematicians occasionally make mistakes, "it is surprising how rare pure mistakes in logic are." To his credit, he then recognizes a highly important point: "Where the really big mistakes are made is in the formulation of premises." He counts it "one of the advantages of the mathematical medium," however, that he and the other model builders "are forced to lay our cards on the table so that all can see our premises" (p. 64). This statement appears at first glance to place mathematical modeling in a favorable light. Yet what advantage is gained if the premises are clearly laid out, seen by everyone to be wholly artificial, otherworldly, or even impossible, and then the deductive game proceeds as if an economic theory based on such premises were perfectly acceptable merely because its premises are so visible and clearly specified? Anyone who has ever mocked the scholastics for counting angels on the head of a pin should try to read an article in the Journal of Economic Theory or any other leading outlet for mainstream economic modeling. Talk about a parallel universe!

"There are," Samuelson insists, "no separate methodological problems that face the social scientist different in kind from those that face any other scientist" (p. 61). This claim flies in the face of what everyone ought to sense intuitively: that human beings, who have purposes, choose means of serving them, change their purposes from time to time, and on occasion devise completely new means, differ fundamentally from electrons, molecules, and light waves (or are they particles?).

Mises expounded methodological dualism persuasively in many of his writings. This exposition appears, for example, at the very beginning of his important and unjustly ignored book Theory and History (1957), where he notes that given our ignorance of "how external events — physical, chemical, and physiological — affect human thoughts, ideas, and judgments of value," the domain of knowledge is necessarily split "into two separate fields, the realm of external events, commonly called nature, and the realm of human thought and action" (p. 1).

He continues: "The sciences of human action," properly construed, "start from the fact that man purposefully aims at ends he has chosen. It is precisely this that all brands of positivism, behaviorism, and panphysicalism want either to deny altogether or to pass over in silence" (p. 3) — or, as in Samuelson's case, to dismiss with ridicule and scorn as unworthy of economic scientists in the modern age. Sad to say, not all change is true progress, and in modern mainstream economics — which we might justly denominate Samuelsonian economics — much of the change in professional precepts and practices has been manifestly for the worse.

Fifteen years ago, Reason magazine invited a number of writers, including me, to contribute a brief entry for a feature called "Know Thy Enemy." The idea was that each of us would "suggest a book published in the last 50 years that is significant because it has helped promote wrongheaded ideas with serious consequences" (December 1993, p. 32). For my contribution, I selected Samuelson's Foundations. If I had to identify such a book today, I still could not think of a more apposite choice.

US stocks spike after Fed decision

Wall Street stocks initially spiked immediately after the the Federal Open Markets Committee cut both the Fed funds rate and a discount rate by 25 basis points, bringing the Fed funds rate to 2 per cent.

The US central bank was careful not to suggest that it thinks the rate-cutting cycle is necessarily over, and left open the option of cutting rates in June, or resuming rate cuts later in the year if required.

But weak growth figures that showed the US economy only narrowly avoided outright contraction in the first quarter may make further cuts more likely, some analysts said.

According to the Commerce Department, first quarter GDP growth was a sluggish 0.6 per cent. More worryingly that number was flattered by rising inventories – a sign that stalling consumer spending and investment is forcing companies to build stocks.

On the positive side, core prices, a measure of inflation, rose a less-than-expected 2.2 per cent, down from 2.5 per cent.

With all ten key sectors in positive territory, by lunchtime in New York the benchmark S&P 500 was up .05 per cent to 1,398.37 while the Dow Jones Industrial Average was 0.9 per cent higher at 12,952.93.

In April as a whole the S&P 500 has added 5.5 per cent thanks to strong results from the likes of Google and Boeing, which have helped ease fears about the likely fallout out from a US slowdown.

The Nasdaq Composite rose 0.4 per cent to 2,438.11.

The day’s portion of earnings reports was mostly positive.

Consumer staples rallied strongly thanks to a handful of better-than expected results from the industry heavy weights. Procter & Gamble led the pack after the consumer-products giant said third-quarter profit hit $2.71bn thanks to better international sales and higher prices.

The numbers beat analysts’ forecasts and combined with plans to sell underperforming businesses, reinforced impressions that P&G, with its strong emerging market presence, was well placed to weather any US downturn. P&G shares rose 2 per cent to $67.20.

Meanwhile, Dean Foods and Kraft Foods bounced after they posted better-than-expected first-quarter profits by successfully passing on rising raw material costs to the consumer.

Dean rose 5.6 per cent to $23.75 while Kraft added 3.4 per cent to $31.81.

Colgate-Palmolive was a rare laggard in the sector after it said first-quarter earnings fell 4 per cent to $466.5m on restructuring charges. Sales grew 16 per cent to $3.71bn but the shares dipped 4.5 per cent to $72.35.

Consumer discretionary stocks also made ground after General Motors reported smaller-than-expected losses for the first-quarter. Automotive earnings improved despite the impact of the American Axle strike and weak domestic markets.

The car company continued its recent strong run, jumping 13.1 per cent to $23.98. It was followed up by peer Ford, which climbed 3.5 per cent to $8.40.

Garmin, the maker of satellite navigation devices, and OfficeMax conspired to limit any major gains in the sector however.

Garmin shares tumbled 10.4 to $41.60 after it blamed poor first-quarter profits and sales on intensifying competition with rival TomTom, which drove down prices.

OfficeMax also slumped after it posted first-quarter earnings that massively undershot analysts estimates. The office supply retailer lost 9.6 per cent to $18.27.

Financials were in focus after Citigroup, the biggest US bank, announced plans to sell $4.5bn of stock to shore up its balance sheet which has been dented by massive writedowns on subprime-related mortgages.

The shares slipped 2.8 per cent to $25.59 as investors worried that the capital raising would dilute their holdings. An index of financial stocks added 0.1 per cent however amid the broader market rally.

Meredith Whitney, an analyst at Oppenheimer, said: “The fact that Citi raised capital at this time did not come as a surprise to us, but the fact that the company raised such a small amount of capital at this time confounds us.”

Ms Whitney estimates that Citi needs to raise an additional $10bn to $15bn or sell several hundreds of billions worth of assets “in order to truly shore up its capital position.”

U.S. Federal Open Market Committee Statement: Text

April 30 (Bloomberg) -- The following is the full text of the statement released today by the Federal Reserve:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 2 percent.

Recent information indicates that economic activity remains weak. Household and business spending has been subdued and labor markets have softened further. Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters.

Although readings on core inflation have improved somewhat, energy and other commodity prices have increased and some indicators of inflation expectations have risen in recent months. The Committee expects inflation to moderate in coming quarters, reflecting a projected leveling-out of energy and other commodity prices and an easing of pressures on resource utilization. Still, uncertainty about the inflation outlook remains high. It will be necessary to continue to monitor inflation developments carefully.

The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate the risks to economic activity. The Committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; Sandra Pianalto; Gary H. Stern; and Kevin M. Warsh. Voting against were Richard W. Fisher and Charles I. Plosser, who preferred no change in the target for the federal funds rate at this meeting.

In a related action, the Board of Governors unanimously approved a 25-basis-point decrease in the discount rate to 2-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of New York, Cleveland, Atlanta and San Francisco.

Fed Lowers Rate to 2%, Seventh Cut Since Credit Squeeze Began

By Craig Torres

April 30 (Bloomberg) -- The Federal Reserve lowered its main interest rate by a quarter of a percentage point to 2 percent, the seventh cut since the onset of a global credit squeeze that's eroded economic growth.

``The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time,'' the Federal Open Market Committee said in a statement after meeting today in Washington. ``The committee will continue to monitor economic and financial developments and will act as needed to promote sustainable economic growth and price stability.''

While a nine-month contraction in credit and soaring fuel prices have pushed the economy to the edge of recession, confidence has begun to return to financial markets. Inflation expectations are also picking up, driven by near record prices for oil and higher food expenses.

``Financial markets remain under considerable stress, and tight credit conditions and the deepening housing contraction are likely to weigh on economic growth over the next few quarters,'' Chairman Ben S. Bernanke and his colleagues said in the statement.

Oil prices marched to another record high of $119.93 a barrel on April 28. The Fed said indicators of inflation expectations have risen. ``The committee expects inflation to moderate in coming quarters, reflecting the projected leveling- out of energy and other commodity prices and an easing of pressures on resource utilization,'' the Fed added.

``It will be necessary to continue to monitor inflation developments carefully,'' the Fed said. Uncertainty about prices ``remains high.''

At the same time, the economy is faltering. Hours before the Fed decision, the Commerce Department reported that gross domestic product increased at an annual pace of 0.6 percent last quarter. Spending by households, the biggest part of the economy, grew at the slowest pace since 2001, when the U.S. economy was in a recession.

Discount Rate

The Fed Board of Governors also voted to lower the discount rate, the cost of direct loans from the central bank, to 2.25 percent. Officials reduced the normal 1-point spread over the federal funds rate in August to a half point to ease liquidity constraints. They further narrowed the difference on March 16, in the first weekend emergency move since 1979.

Dallas Fed President Richard Fisher and Philadelphia Fed President Charles Plosser dissented from today's decision, preferring no change. They also objected to last month's reduction.

Central bankers have reduced the interbank lending rate 2.25 percentage points in 2008 with a series of aggressive rate actions, including two three-quarter point cuts and one half- point cut prior to today's move. In addition, the Fed resorted to an emergency authority in March and opened a direct loan window for investment banks.

Creaking Into Life

The actions have reduced risk premiums for financial firms, and stock prices have climbed since the previous Fed meeting on March 18.

The Standard & Poor's 500 Index has rallied since Fed officials last met. Yields on five-year obligations of Fannie Mae, the largest U.S. mortgage company, have fallen to 0.56 percentage points over Treasury notes of similar maturity, down from 0.90 percentage point.

``Credit markets seem to have stabilized in most areas,'' Brian Sack, senior economist at Macroeconomic Advisers LLC in Washington, said before the meeting. ``We believe that the Federal Open Market Committee is ready to slow the pace of its actions.''

The world's biggest financial companies have posted at least $312 billion in writedowns and credit losses tied to U.S. mortgage markets as of April 28. U.S. foreclosure filings more than doubled in the first quarter as payments rose for subprime adjustable mortgages. One in every 194 U.S. households, or 650,000 properties, were in some stage of foreclosure during the quarter, according to Irvine, California-based RealtyTrac Inc., a vendor of data.

Hastening Inflation

While easing borrowing constraints, the central bank has also pushed money market yields below inflation, giving consumers an incentive to spend or take on more risk in their investments to earn a return. The Fed's preferred inflation barometer, the personal consumption expenditures price index, minus food and energy, rose at a 2.2 percent annualized rate in the first quarter. Six-month Treasury bills yield 1.7 percent.

Five-year-ahead inflation expectations measured by the Reuters/University of Michigan survey rose to 3.2 percent April, the highest level since October 2005.

``If they do lose credibility as an inflation-fighting institution, they will find it much harder to do anything,'' James Hamilton, an economist at the University of California, San Diego, said in a television interview before the meeting. ``It is a slope you do not want to start sliding down, and I am afraid the Fed has already started.''

Meanwhile, housing markets are still in a slump. Home prices in 20 U.S. cities fell in February by the most on record. The S&P/Case-Shiller home-price index dropped 12.7 percent from the same month a year earlier, the most since the figures were first published in 2001. Builders broke ground on 947,000 new homes at an annual rate in March, the fewest since March 1991.

Food crisis is a chance to reform global agriculture

By Martin Wolf

Of the two crises disturbing the world economy – financial disarray and soaring food prices – the latter is the more disturbing. In many developing countries, the poorest quartile of consumers spends close to three-quarters of its income on food. Inevitably, high prices threaten unrest at best and mass starvation at worst.

The recent price spikes apply to almost all significant food and feedstuffs (see charts). Yet these jumps are themselves part of a wider range of commodity price rises. Powerful forces are linking prices of energy, industrial raw materials and foodstuffs. Those forces include rapid economic growth in the emerging world, strains on world energy supplies, the weakness of the US dollar and global inflationary pressures.

Yet the food element of this story carries its own significance. As HSBC points out in a recent analysis*, with rice and wheat prices spiking, riots on the streets of the Philippines, Egypt and Haiti and moves by India, Vietnam, Cambodia and China to restrict rice exports, food is suddenly an even hotter issue than normal.

So why have prices of food risen so strongly? Will these higher prices last? What action should be taken in response?

On the demand side, strong rises in incomes per head in China, India and other emerging countries have raised demand for food, notably meat and the related animal feeds. These shifts in land use reduce the supply of cereals available for human consumption.

Furthermore, rising production of subsidised biofuels, further stimulated by soaring oil prices, boosts demand for maize, rapeseed oil and the other grains and edible oils that are an alternative to food crops. The latest World Economic Outlook from the International Monetary Fund comments that “although biofuels still account for only 1½ per cent of the global liquid fuels supply, they accounted for almost half of the increase in consumption of major food crops in 2006-07, mostly because of corn-based ethanol produced in the US”.

Meanwhile, aggregate production of maize, rice and soyabeans stagnated in 2006 and 2007. This was partly the result of drought. Also important, however, have been higher prices of oil, since modern farming is so energy-intensive. With weak growth of supply and strong increases in demand, cereal stocks have fallen to their lowest levels since the early 1980s. Declining stocks undermine the widely shared belief that speculation has driven the rising prices, since stocks would be rising, not falling, if prices were above market-clearing levels.

Vastly more worrying than speculation is the weak medium-term growth of supply. The rapid increases in yields of the 1970s and 1980s, at the time of the “green revolution”, have slowed. Given the stresses on water supplies, longer-term supply prospects would look poor even if diversion of land for production of biofuels were not adding to the pressure.

Are prices going to remain high? Two opposing forces are at work. The first is the market, which will tend to bring prices back down as supplies expand and demand shrinks. But the latter is also what we want to avoid, at least in the case of the poor, since reducing their consumption is not so much a solution as a failure. The second force is the current intense pressure on the world’s food system. This is true of both demand and costs of supply. Prices are likely to remain relatively elevated, by historical standards, unless (or until) energy prices tumble.

This, then, brings us to the big question: what is to be done? The answers fall into three broad categories: humanitarian; trade and other policy interventions; and longer-term productivity and production.

The important point on the first is that higher food prices have powerful distributional effects: they hurt the poorest the most. This is true both among countries and within them. The Food and Agricultural Organisation in Rome recently listed 37 countries in substantial need of food assistance. Moreover, according to the World Bank, soaring food prices threaten to make at least 100m more people hungry.

Increases in aid to the vulnerable, either as food or as cash, are vital. Equally important, however, is ensuring that the additional supplies reach those in greatest difficulty. The options depend on the sophistication of a country’s bureaucratic machinery. But they include work paid directly with food (which is a good way of screening out the better-off), a rationed supply of cheap food for the poor or cash vouchers. Those most in need will be the landless, both rural and urban, and marginal subsistence farmers.

Now turn to the policy interventions. Protection, subsidies and other such follies distort agriculture more than any other sector. Alas, the opportunity to eliminate protection against imports offered by exceptionally high world prices is not being taken. A host of countries are imposing export taxes instead, thereby fragmenting the world market still more, reducing incentives for increased output and penalising poor net-importing countries. Meanwhile, rich countries are encouraging, or even forcing, their farmers to grow fuel instead of food.

The present crisis is a golden opportunity to eliminate this plethora of damaging interventions. The political focus of the Doha round on lowering high levels of protection is largely irrelevant. The focus should, instead, be on shifting the farm sector towards the market, while cushioning the impact of high prices on the poor.

Finally, far greater resources need to be devoted to expanding long-run supply. Increased spending on research will be essential, especially into farming in dry-land conditions. The move towards genetically modified food in developing countries is as inevitable as that of the high-income countries towards nuclear power. At least as important will be more efficient use of water, via pricing and additional investment. People will oppose some of these policies. But mass starvation is not a tolerable option.

The food and fuel crisis of 2008 is a cry for our attention. Nobody knows how long these shocks will last. But they demand rapid policy changes across the globe. We must choose between fragmenting world markets still further and integrating them, between helping the poor and letting even more starve and between investing in improving supply and allowing food deficiencies to grow. The right choices are evident. The time to make them is now.

PARAGUAY

Between liberation theology and evils of the past

By CARLOS ALBERTO MONTANER

www.firmaspress.com

His name is Fernando Lugo, a former Catholic bishop, and he projects the image of a good person, genuinely concerned by the calamities afflicting his Paraguayan compatriots.

What are those calamities? Basically, the poverty of much of society. Paraguay is South America's second-poorest country, trailing Bolivia. Its per capita income -- measured in purchasing power, which is the fairest way to gauge it -- barely reaches $4,000 annually. That's half of its Brazilian neighbor's, one-third of Argentina's.

Lugo also has denounced some of the causes of Paraguay's ills. He thinks the worst are corruption and patronage. He's probably right. According to Transparency International's rankings, released in 2007, Paraguay is one of the world's most corrupt countries, listed at no less than 138th place. On a scale of one to 10, where 10 is the most honest and one the most corrupt, the Paraguayans suffer a corruption index of 2.4. In Latin America, more rotted than Paraguay are only Ecuador (2.1) and Hugo Chávez's Venezuela (2.0), which is Ali Baba's den with 40,000 thieves who have exchanged their camels for Hummers.

In reality, all analyses agree on the same melancholy diagnosis. In Paraguay, no accounts are rendered, justice does not work and the quality of official management and public policies is pitiful. The result? Total divorce between society and state. A breakdown that explains another horrid fact: According to the latest Latinobarometer, only 33 percent of Paraguayans believe that democracy is the best form of government, while 36 percent would unabashedly support some sort of authoritarian adventure.

That state of frustration is the natural consequence of 61 years of misgovernment by the Colorado Party. But let's not forget that during that very long period, which includes the 35 years of Gen. Alfredo Stroessner's iron-fisted regime, the Colorado Party enjoyed the support of a substantial portion of the Paraguayan people. In the recent elections, Lugo was able to win with 40 percent of the vote because his Colorado rivals went to the polls bitterly split into two camps that garnered 30 and 21 percent of the vote, respectively.

The Paraguayans, therefore, have been the victims not only of the bad Colorado leaders but also of their accomplices, a fact that shouldn't scandalize us. It happens in all states where patronage-based relations exist. In them, political power becomes the grand source of wealth, privileges, public jobs and social prestige; or, at the other end, the hard hand that punishes, robs or cruelly persecutes its adversaries. That is why patronage-based governments (ask the Argentines about Peronism) have so many supporters.

Lamentably, Lugo, who is so accurate when identifying the ills that beset the country, proposes to correct them with the wrong ideas. He has declared himself to be a follower of Liberation Theology, a harebrained economic and philosophical prescription expounded in 1971 by a Peruvian priest, Gustavo Gutiérrez.

Who was he? A good man, poorly educated in economic issues, who attributed Latin Americans' poverty to the perfidy of capitalism and the evil designs of the prosperous nations of the developed world: a heartless center that had assigned societies in the periphery the sad role of suppliers of raw materials, a perverse abuse that justified a recourse to insurrection and explained the admiration felt by Gutiérrez and his followers for the Cuban dictatorship and Guevarist revolutionary violence.

It is a pity that Lugo opted for Gutiérrez, so totally misguided, instead of carefully reading American Catholic theologian Michael Novak, an advisor to Pope John Paul II and the author of The Spirit of Democratic Capitalism.

It is sad that he wasted his time with the Theory of Dependency (the absurd concept behind Liberation Theology) instead of turning to another, truly enlightened priest, Robert Sirico. From his Acton Institute in Michigan, Sirico devotes all his energy to teaching priests and Catholic believers the basic elements of modern economy, lest they disseminate foolish ideas that aggravate the enormous problems suffered by the poor whom, paradoxically, they attempt to help.

Now that former Bishop Lugo is about to become president, it would behoove him to meditate upon the responsibility he has assumed. It is true that the Colorado Party ruled abominably during many decades, but if he takes the wrong road, he will inevitably worsen the existence of his compatriots. This would be an unforgivable outcome for someone who has spent his life preaching with sincerity the importance of compassion.