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Jewish World Review Jan. 17, 2001/ 22 Teves 5761

Lawrence Kudlow

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New Bull? -- HELP is on the way. Following the Fed rate cut of January 3 the Nasdaq stock index has increased 13½%. This week it has risen three consecutive days. Imagine that.

Since the Fed turned tail and finally figured out that recession, not inflation, is economic problem #1, the broader S&P 500 index has increased 3% and the Dow is about flat. Nothing to write home about just yet, but keep hope alive.

According to Boston-based economist Richard Salsman, the S&P on average rises 19% during the first year after the central bank cuts rates at least 50 basis points. That would put the index at 1523. When the central bank lowers rates by 175 basis points or less, then the S&P on average rises 32% during the rate-cutting period. That would push it to 1690.

Additionally, the Dow Jones industrial average goes up by an average of 20% a year after the Fed first cuts its key policy rate, according to Ned Davis Research in an article by Investor's Business Daily. But the biggest impact comes after the second rate cut when the market was up an average 28½%. That would take the Dow to 13,492.

So an interesting question is: How much might the Fed lower its key policy rate? Answer: risk-free Treasury market prices suggest that we could be looking for a 4¾% federal funds rate this year, compared to 6% now.

How to reach this conclusion? Inflation-adjusted Treasuries (TIPS) maturing July 15, 2002 are presently yielding 3.1%. This infers the real rate of interest for the U.S. economy over the next eighteen months. It could even be construed as a real GDP growth rate forecast between now and the middle of next year, consistent with average profits growth of at least 5% (on a national income accounts basis).

Meanwhile, two-year Treasury notes maturing December 31, 2002, the nearest match to the eighteen month TIPS, are presently yielding 4.75%. Subtracting the 3.1% real yield from the 4.75% market rate leaves an inflation forecast of 1.65% for the next year and a half.

In a Wicksellian market-price rule model, the 3.1% "natural" rate of interest combined with the 1.65% expected inflation rate generates a 4.75% central bank policy rate. Hence, the Fed could reduce its overnight funds rate another 125 basis points from the current level, thereby totaling 175 basis points all told. That is, if Fed members junk their Phillips curves and adopt a market-based monetary strategy.

Interestingly, futures markets for the federal funds rate and euro-dollar rates infer a 5% funds rate in June. Both these markets are predicting another 50 basis point Fed rate decline at the meeting on January 31, then a quarter point decline by April, and another quarter point by June.

All this is good news for the stock market. Really good news. Help is on the way. Future economic growth will rally after the autumn-winter prosperity pause.

Though by no means completely guaranteed, the basic notion that reducing the fed funds rate will provide a greater volume of high-powered liquidity is likely to pan out. In other words, after deflating the monetary base for the better part of the past year, the Fed will be able to expand the base -- without compromising its basic mission of domestic price stability.

But here's an interesting point from economist Salsman. Too much Fed easing can generate rising inflation fears that burden stocks. For example, over the past thirty years fed funds rate reductions of 175 basis points or more led to only a 10% S&P 500 average gain, just a third of the 32% average gain when the Fed reduced rates by 175 basis points or less.

This is a warning to those supply-siders and others who want to see the Fed inflate liquidity so as to raise gold over $300. Remember, during 1999's second half the 50-day moving average gold price reached $300 (from $255), as monetary base growth surged to 18% and 10-year Treasury rates jumped to 6½% (from 5.40%). This temporary bout of monetary inflation paved the way for a sinking stock market in 2000.

Ideally, a front-ended program of lower personal tax-rates made retroactive to January 1, 2001, would generate more production of goods to absorb additional Fed liquidity. This non-inflationary balance between money supplied by the central bank and money demanded by a goods-producing economy provides the optimal policy mix for prosperity and wealth.

Fortunately, front-ended tax relief is gathering momentum in Washington. In fact, Bush's across-the-board rate reduction plan is beginning to attract bi-partisan support. Witness House Democratic leader Richard Gephardt's recent musings on the need for a large tax cut.

Pollster John Zogby has just released a survey that shows a majority of likely voters nationwide favors the Bush plan by 53% to 34%. Bush's own approval rating has skyrocketed to 65% according a USA Today/CNN Gallup Poll. Eighty-one percent of the respondents rated Bush's cabinet appointments either outstanding, above average or average; only 13% believed them to be below average or poor. W. is off to a good start.

Did anyone say new bull market?

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.


12/19/00: Help is on the way
12/04/00: Slumbering spirits
09/19/00: Euroland Tax Revolt is Good for the Europe
08/24/00: Tax Cut Issue in Campaign
07/31/00: Mr.G., you’re gaining on it
07/26/00: Investor Class Rising
07/17/00: The rising tide of national prosperity is lifting all boats
07/11/00: On Soft landings
06/29/00: Is the sky falling?
06/21/00: Internet-more-important-than-Fed update
06/14/00: The judicial hacker
05/16/00: Front-View Windshield
05/09/00: Don't Overreact
05/05/00: Give it Back
05/01/00: Wealth and Capital
04/18/00: Growth, Freedom and the New Investor Class--Stay the course
04/13/00: Correct Value
03/28/00: Governments roil the Markets
03/28/00: Fed should keep its powder dry
03/14/00: Reduce Debt, Derail Economy
02/17/00: Unsettled
02/10/00: Bush's Footprints
01/25/00: To preserve its standing as the world's number one economic power
01/06/00: It's not the '70s
12/28/99: They missed it
12/23/99: Bonditos
12/20/99: Dracula's Curve
12/16/99: When Alan Greenspan sneezes, Wall Street economists catch cold
12/10/99: Y2K-Related Cash
11/23/99: Y2K Money: Inflationary or Not?
11/16/99: Investor Retaliation
11/05/99: Rosy Lives
10/29/99: Drain Reserves
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