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Jewish World Review May 3, 2001/ 9 Iyar 5761

Lawrence Kudlow

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Keep the Faith -- BETTER times are coming for the stock market and the economy according to a number of market-based financial and commodity indicators. Also, money supply statistics are pointing in the same positive direction. And, easier tax policy in the form of lower marginal rates on personal income and capital gains is a distinct possibility.

Though full economic recovery probably won't appear until next year, it is likely that a sizable stock market rally has already begun. As is always the case, stocks lead the economy by six to nine months.

This optimistic view is based on growing evidence that Fed-induced liquidity deflation is ending. In particular, the shape of the Treasury yield curve has moved from inversion to normalcy. Yield curves tend to lead the economy by six to nine months.

The Fed's single biggest mistake was ignoring the recession-warning yield curve inversion that developed last year. This classic economic slump indicator, which began in February 2000, turned out to be a more reliable leading economic indicator than backward-looking GDP results or the growth-is-inflationary Phillips curve that contaminates the Fed's collective institutional mind.

Now, however, the 3.80% three-month Treasury bill rate is well below the 5% 10-year Treasury yield. So the positive yield curve spread is almost 145 basis points. A more normal economic recovery spread would be about 225 basis p

oints. The 4% fed funds rate should come down at least another 50 basis points, and perhaps 100 basis points, to be more in line with T-bills. Also, the funds rate should be well below the 4% two-year Treasury note in order to open up a "positive carry".

This positive carry would encourage banks to inject credit into the economy by purchasing two-year notes for their investment accounts. Loan demand is dormant as businesses slash inventories (there was an abrupt information-age inventory decline of $63 billion in the first quarter GDP report), but bank investments normally pick up the credit slack during recession-recovery turning points. Credit creation is vital to economic recovery.

So the Fed still has more work to do. This point is bolstered by recent monetary base data that show high-powered liquidity has actually declined at a 1.5% annual rate over the past three months, after rising at a 5.4% yearly pace during the prior nine-month period. More constructive is the fact that monetary base growth measured over twelve months has accelerated from minus 2.5% in December 2000 to plus 3.8% through mid-April 2001.

Base growth is controlled by Fed purchases of Treasury securities, paid with bank reserves and currency injected into the financial system. Money creation is a dynamic process, based on Fed liquidity injections (or withdrawals) and the public's demand for money.

Rising interest rates reduce money demands (think of it as a tax on money) while falling rates increase money demand (a tax cut on money). The broad M2 money aggregate is representative of the public's demand for money (and liquidity). Over the past three months M2 growth has surged to nearly 14% annually, temporarily bolstered by falling interest rates, as well as high cash balances parked in money market funds for tax payment purposes and prior stock market flight.

Adjusting for these temporary factors, underlying M2 growth is probably around 6% to 7%. However, less than 4% monetary base growth over the past year is insufficient to adequately finance rising money demand (and economic growth).

So the Fed needs to further reduce the funds rate and inject more base liquidity into the economy. Put another way, the financing gap between base growth and M2 growth (measured over 12-month periods) still shows a shortage, or deficit, of liquidity. To promote economic expansion, this gap must be eliminated.

The Fed's shock therapy of two weeks ago, when the funds rate was unexpectedly cut by 50 basis points, was certainly a big step in the right direction. Since then the CRB commodity futures index has stopped declining, gold is up a bit, and the dollar exchange rate index is off slightly. All indicate greater monetary stimulus. Not inflation, merely a shift from deflation to stability. Similarly, since late March 10-year Treasury rates have increased to 5% from 4%, another sign that liquidity deflation is ending. In a non-inflationary recovery, 10-year notes should trade around 5% to 5%.

While financial markets are moving away from a "recession trade" (sell stocks to buy bonds and cash) to a "growth trade" (buy stocks and sell bonds), there's another key indicator signaling an end to liquidity deflation.

Namely, a significant rally in gold stocks. The gold stock index published by Investor's Business Daily is the best performing group this year, rising over 16% year-to-date and 20% over the past three months. Without any interference from central bank gold sales, gold stocks may be a more representative signal of liquidity conditions.

Corroborating the IBD gold index, the Dow Jones industry group breakdown shows a nearly 19% year-to-date rise in mining and metals, with the precious metals component up 11%. Only autos (+20%) performed better. Among the broad industry groupings, consumer cyclicals are up 7%, energy is up 4% and telecoms up 1%. Everything else is down, including consumer non-cyclicals (-6%), financials (-7%), healthcare (-16%), industrials (-4%), technology (-18%), and utilities (-3%).

The rise of gold shares, along with a more normal yield curve, a turnaround in year-to-year monetary base growth, and a generalized interest rate decline from year ago levels, all point to a more positive liquidity environment that forms the basis for an improved economic outlook.

Punctuating the turn in monetary policy, a front-ended tax cut beginning this summer would spur capital formation, production and economic growth. Improving prospects for accelerated income tax-rate reduction, along with capital gains tax reform that lowers the top rate to 15% from 20%, and eliminates the one-year holding period, could bring economic growth up to the 3% to 4% zone by next year's first-half.

Better times are coming. Stay invested. Keep the faith. Faith is the spirit.

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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