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Jewish World Review May 14, 2001/ 21 Iyar 5761

Lawrence Kudlow

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How truly stimulative is Fed policy? -- AT first blush it's a silly question, since everyone knows the central bank has been cranking down interest rates at a near-record pace. The fed funds policy rate was dropped a full percentage point in January, then fifty basis points in March and April, for a total of two percentage points in four months, from 61/2% to 41/2%.

But wait a minute. Other short-term interest rates have actually fallen more. Three-month Treasury bills, for example, have descended to 3.70% from 61/2% over the past five months, a 280 basis point plunge that is over three-fourths of a percentage point deeper than the fed funds rate fall.

This suggests that the Federal Reserve is still way behind the curve. They are following weak bank reserve and economic demands on the way down, but not really stimulating the volume of high-powered liquidity that is necessary to foster new credit creation and economic growth.

Normally, three-month T-bills are about 10 basis points below the overnight funds rate. Using this as a guide, the Fed's policy rate should be 31/2%, not 41/2%.

Looked at another way, the inversion of the short end of the Treasury yield curve should be normalized upward from the overnight fed funds rate out to the two-year Treasury. The rest of the Treasury curve is now upward sloping, a good thing. But the 4.10% two-year note is still nearly one-half of a percent below the overnight funds rate. This is a problem.

A truly stimulative yield curve would have the two-year note well above the fed funds rate. This would set up a "positive carry" that would induce banks to borrow from the funds market and purchase low risk two-year notes. In the process, banks would be creating much-needed credit for the economy by injecting cash into the broker-dealer markets.

But banks are not likely to inject liquidity into the economy unless the Fed provides a more generous volume of high-powered reserves to the banking system. The basic measure of Fed liquidity is the monetary base, comprised of bank reserves and currency created by the government bank through its net purchases of Treasury securities (Federal Reserve credit).

However counter-intuitive after numerous fed funds rate cuts, the fact is that the adjusted monetary base (published weekly by the St. Louis Fed) has actually deflated at a 1.3% annual rate over the past three months. Even worse, following a temporary growth spurt of 8.9% annualized rate for the three months to February 7, the recent 1.3% annualized rate of base shrinkage for the three months to May 2 amounts to a 10.2% decline rate in the second difference change in the rate of change.

This tight money episode helps explain the inversion of the short end of the Treasury curve from overnight federal funds (4 1/2%) out to the two-year Treasury note (4.11%). It also helps explain why the gold price remains flat at the low end of its four-year range.

If monetary policy were truly stimulative, then reserves supplied by the Fed would be greater than reserves demanded by the economy. At least over the next six months, 6% to 10% monetary base growth would be a reasonable growth range.

In those circumstances the fed funds rate would decline significantly more, the short end of the Treasury curve would steepen appreciably and gold prices would temporarily spurt by about $25 (10%).

This analytical model of monetary base growth, the shape of the Treasury curve and the gold price will tell the real Fed story. Merely tracking the funds rate can be very misleading.

Though the level of the monetary base jumped nearly $9 billion last week, perhaps the beginning of a new stimulative monetary cycle, so far this year the real story is that central bank policies have merely followed the economy on the way down. True stimulus has yet to emerge. But we're all waiting.

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