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Jewish World Review August 20, 2001/1 Elul 5761

Lawrence Kudlow

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Consumer Reports

Straws in the wind? -- IT might be tempting, at first blush, to dismiss recent movements of sensitive market price indicators that are finally pointing, however tentatively, toward a modicum of real monetary relief after 275 basis points in funds rate cuts so far this year. Earlier signs of an easing in liquidity conditions, as for example when the dollar price of gold shot above $285 per ounce following the Fed's May 15 rate cut to 4%, turned out to be false. After that brief surge, gold fell back to its previous $265-$268/oz. range, which is where it stayed - with but fleeting exceptions -- until late last week. At those prices, spot gold continued to trade below the $270/oz. levels extant at the time of the Fed's first rate cut in early January. Despite the succession of rate reductions, in other words, the market's most sensitive gauge of money purchasing power showed no evidence of an easier policy stance, an assessment backed by the deflationary tendencies of a number of broad commodity price indexes. Certainly, it would be premature to rule out the possibility that the recent $7-$8 jump of the yellow metal to around $275- $276/oz. will prove to be another head fake, and that a liquidity-scarce Fed stance will soon be manifest again in a variety of market indicators. There are, though, a number of encouraging straws in the wind. Unlike the May episode, during which gold was isolated in indicating a relatively less stringent monetary climate, the current rally finds corroboration in several other measures of dollar liquidity.

  • Foreign exchange. Since peaking at 15-year highs in early July, the G-6 trade-weighted dollar index has fallen by about 6%. For most of that period, it's true, the index was capturing a real strengthening of major foreign currencies rather than an absolute easing of the greenback. For example, while the dollar remained relatively stable in gold terms, the euro's rise from below $.84 to $.88 by early last week translated to a 4% strengthening for the common currency against gold, from e317 to e304. Since then, as the dollar's value against gold has declined by about 3%, the euro has continued rising against the dollar to about $.91, while remaining essentially stable in gold terms. Unlike the gold price pop in May, when the price rose almost equally in all major currencies, indicating a speculative trading event in the metal with little monetary significance, this suggests the recent move reflects a marginal dollar decline .

  • Commodities. After declining steadily for much of this year, several benchmark commodity indexes at least are showing signs of bottoming out. The CRB futures index, for example, after plummeting at an annual rate of about 26% since early March, has been rangebound at the 200 level since early this month. Similarly, the JoC industrial metals index, which has fallen at an annual rate of about 30% the past six months, has bounced off its lows and appears to be establishing a trading range, albeit it at a level some 17% below year-ago levels.

  • Money supply data. Here we are observing early evidence of a rebalancing in the supply of dollars relative to demand. Perhaps most significant, recent Fed data suggests the demand for risk-free, interest-bearing money-fund type cash balances may finally be waning. As we have noted previously, this risk-averse excess cash demand was seen most vividly in the explosive growth of institutional money funds, which rose at an annual rate of about 66% in the first six months of the year. Such balances offer not only a safe harbor in a highly uncertain financial climate, but in a deflationary environment, money is an appreciating commodity that provides an expected real-return premium on cash. In the past few weeks, however, demand for these holdings appears to have plateaued, and for the first time this year institutional money fund balances are now running below month-earlier levels.

    At the same time, indications are that the Fed's injections of high-powered liquidity have also accelerated. For one thing, the three-month annualized growth rate of the monetary base has shifted to a positive 11% from a negative 1% in the previous three-month period. The trend can also be seen in growth of the Fed's balance sheet assets, which are now rising year-on-year at a rate of 6.5%, up from less than 3.5% in early May. Recall that the May rate cut for the first time established a positive spread between the funds rate and the short end of the Treasury yield curve. That, it appears, has encouraged a degree of new asset creation in the banking system, spurring a marginal increase in demand for reserves, which the Fed has accommodated to keep the funds rate trading at target.

These are still-preliminary signs that the Fed may have gotten to the point in this easing cycle that it should have reached long ago. Falling short-term rates appear finally to be reducing the demand for risk-free interest-earning cash while encouraging a higher rate of base growth, helping to rectify the shortfall of money supply relative to demand. It would be a mistake at this point, though, to take these positive signs as evidence that the Fed's task is complete. To considerable extent, they appear to rest on expectations of further Fed action, including sanctioning a cut of at least another 25 basis point next week. Let's keep hope alive.

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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