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Jewish World Review Oct. 29, 1999 /19 Mar-Cheshvan, 5760

Lawrence Kudlow

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Drain Reserves -- FOLLOWING THE RELEASE of the latest consumer price report, which rose 2.6% above a year ago and 3.5% at an annual rate over the past six months, I remain concerned that inflation is creeping higher. The producer price report earlier registered a 3.1% year-to-year gain in September, or 4.9% at an annual pace over the recent six months. Even temporarily, too high.

Leading up to these price reports, which hint that inflation could be rising above the Fed's implied zero to 2% price rule inflation target, gold and precious metals turned up this summer (from a low base), broad commodity indexes increased modestly (following eighteen months of deflation), and the overall dollar index dropped slightly from its peak.

Perhaps most important, after two fed funds rate increases, 30-year Treasury bond rates actually increased from about 5.80% to 6.3%. Traditionally, if Fed restraining actions successfully reduce future inflation expectations, then long rates would decline even as short rates increased.

But this has not yet happened. Today's spread between the actively traded long bond yield and the fed funds rate is slightly above 100 basis points, nearly identical to the "policy" spread last spring before the Fed turned to a more cautious approach.

Now, my point in all this is that the bond market sees some inflation, though not much. Inflation signs are creeping up. Creeping, not galloping. This is most assuredly not a 1970s threat. Nor, even, does it look like a late eighties problem, when the inflation rate moved up to 5% from 2%. Additionally, it is very unlikely that interest rates need to ratchet up as they did in 1994.

Washington economist Alan Reynolds, who shares this creeping inflation view, recently noted two additional threats. First, second quarter import prices (including oil) rose 1.6%, or 6.8% at an annual rate. Updating this for the third quarter, we find that import prices rose 2.5%, or 10.3% annualized. This cuts into consumer buying power and will likely slow future consumer spending.

Second, Reynolds notes that while the personal spending deflator (the CPI of the national income GDP accounts) rose 2.2% at an annual rate in the second quarter, prices of non-durable goods jumped at an outsized 5.3% yearly rate. For the third quarter, the non-durable component of the CPI has increased 4.6% at an annual rate.

Speaking of a possible consumer slowdown, my associate John Park reports a clear link between the Bank of Tokyo Mitsubishi-Schroders leading index of chain store sales and overall retail sales ex-autos. The accompanying chart shows the downturn in the growth of this leading index, a trend shift implying that non-auto retail sales could drop from nearly 8% to roughly 3%. Even a small non-energy shift in the import price terms-of-trade can be a drag on growth.

Now, contrary to the usual Phillips curve chorus of economists who believe that strong growth and employment cause inflation to rise, the classical monetary view asserts that declining money purchasing power generates inflation. Then, rising inflation harms growth.

The message from lower bond prices and somewhat higher gold and commodity prices, corroborated by the up-creep in government inflation reports (flawed as they are), is that the value of dollar purchasing power has eroded somewhat. Therefore, future growth is likely to be slightly lower, while inflation will come in a bit higher.

This is likely to be a minor problem, not a major one. There's no recession in sight. Next year's growth could be in the 2 1/2% to 3% zone, while general inflation hovers around 2%.

There are risks, however. Mainstream Keynesians never acknowledge that period of rapid growth, such as the past four years, or most of the 1980s, are usually accompanied by slower inflation. In contrast, periods of slower growth, such as the early 90s, or the 70s, are associated with higher inflation.

Should growth in fact slow, then the Fed must be aware of the likelihood that the demand for money will also slow. Therefore, in order to avoid worse inflation, the central bank should withdraw liquidity to rebalance less money demand with less money supply.

This is why I believe the Fed needs to drain reserves from the banking system -- in order to prevent "excess liquidity" from accommodating higher oil prices and other small price increase pressures.

This is also why the Fed should stop attacking the stock market and economic growth. They must realize that "talking down" the economy and the market really means talking down the dollar.

If investors in search of high economic and investment returns really believe the Fed, then they will switch out of dollars into yen or other currencies where future returns are more promising. This process would further reduce dollar demand. As such, the existing dollar supply becomes excessive, or inflationary, in relation to falling dollar demand.

Instead, Greenspan & Co. should broadcast their intent to keep inflation in a zero to 2% target zone. If price indexes rise above this target band, then liquidity should be drained. If prices fall below the band, then liquidity should be added.

Right now the near $300 gold price suggests that future inflation will not be much of a problem. My price rule and supply-side friends who believe that recent inflation will prove temporary are likely to be right, though bond yields remain a worry-wart.

I continue to believe that the Internet economy exerts an upward push to economic growth and productivity, and a downward push to inflation. Over the next few decades, the Internet will be much more important that the Fed.

However, I also believe the monetary scarcity creates purchasing power value and zero inflation. This, in turn, creates a favorable growth climate for technology entrepreneurs and their venture capital financiers.

So I think the Fed needs to drain reserves right now to maintain the Greenspan standard of price stability. Aim policy at steady prices, not economic growth. Growth should be nurtured, not harmed. Then the long bull market prosperity boom will continue well into the new century.

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


10/22/99: Supply-Side Is Mainstream
10/14/99: Y2K will likely bring more prosperity
10/07/99: Clinton's tax-cut veto
10/01/99: What's really bugging the stock market?
09/23/99: Growth Trade
09/09/99: Bad Dollar Logic
09/09/99: Buttered bread
08/31/99: Bull Market Alive and Well
08/26/99: Let Prices Rule
08/19/99: Blame OPEC, Not Growth

©1999, Lawrence Kudlow