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Jewish World Review May 23, 2001/ 1 Sivan 5761

Lawrence Kudlow

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Fed breather

http://www.jewishworldreview.com -- AS previously noted, forward-looking liquidity and inflation-sensitive market price indicators are signaling the wisdom of at least a temporary end to the Fed's easing actions following the last two interest rate drops that brought the federal funds rate to 4%.

Rising gold, a jump in Treasury bond rates, a widening of the TIPS spread between 10-year Treasuries and 10-year inflation-indexed Treasuries all suggest that the Fed has done enough for now. King dollar, which has increasingly become world money, remains strong and stable.

Now some market skeptics are predicting a rising inflation rate over the next year, largely because broad money supply aggregates have been growing rapidly of late. However, we have shown that the bulge in MZM and M2 is largely a result of a precautionary build-up of money market fund balances from prior stock market flight and tax-related activity.

What's more, the velocity, or turnover rate of MZM and M2 plummeted during the first quarter, thereby neutralizing much of the money supply spike. Plunging velocity strongly implies that the money market build-up is not being used for transaction demand or investment purposes. Consequently nominal GDP growth, or total spending in the economy, is likely to remain in its current range of only 4%-5% growth, proving no new inflationary dangers in the period ahead.

Actually, a simple inflation forecasting model using the prior level of gold prices to predict inflation twelve months ahead produces a very optimistic forecast of 1% inflation by mid-2002, down from roughly 2% currently. The model uses the consumer personal spending deflator.

In effect, this benign inflation view captures the low average $280 gold price registered over the past three years and the $270 gold level over the past twelve months.

Confirming this, 10-year Treasury rates of 5.35% today are 100 bps below year ago levels, while the dollar exchange-rate index has appreciated 5% despite the U.S. economic slowdown. Additionally, with energy prices generally coming down, most spot and future commodity indexes are descending.

All this suggests that there's no "excess money" in the financial system.

Indeed, until recently the major problem has been a shortage of high-powered monetary base money.

The recent upturn of market-based inflation indicators anticipates stronger monetary base growth and a move from deflationary money to the future provision of liquidity resources that will be sufficient to finance some sort of economic recovery. Think of it as a shift from liquidity deflation to liquidity stability. Really nothing more than that.

If, however, the Fed stubbornly insists on looking backward through the lens of GDP, then the danger of excess money creation through additional easing moves will weigh negatively on the markets. Rising long-term bond rates, for example, would increase the discount factor that capitalizes future earnings. In that event, a rising 10-year Treasury yield would undermine a modest profits rebound by actually reducing capitalized corporate profits. This would pull stock indexes down.

Of course, a more aggressive tax-cut bill - especially one that lowers the capital gains tax-rate - would raise the investment demand for liquidity. The appropriate Fed response would then be the creation of additional high-powered money that could be consistent with a lower fed funds rate.

All that is in the future. For now, the market is telling the central bank to take a breather. Since markets are smarter than Phillips curves or GDP, let's hope the Fed is listening.


JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.

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©2001, Lawrence Kudlow