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Jewish World Review May 18, 2001/ 25 Iyar 5761

Lawrence Kudlow

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Consumer Reports

EPA Inflation -- A SLIGHT inflation-whiff is in the air, driven largely by a temporary but highly publicized (and politicized) spurt in gasoline pump prices.

Over the past month regular ($1.70) and premium ($1.88) unleaded gas at the pump has increased 13 1/2% according to the AAA nationwide indexes. In the futures markets, the near-term NY unleaded gas contract has increased by a net of nearly 17% since early April (actually up 32% since late February), though the contract has retreated 7% from its late April peak.

This short-term energy spike has to some extent infected interest rate movements, and of course is picked up in the monthly CPI and PPI reports. However, it will also have the tax-hike effect of depressing economic activity.

Fortunately, the gas price problem has not spread more generally to other energy markets. From their peaks, electricity and natural gas prices are down nearly 60%. Crude oil is off more than 25%.

If these energy price levels hold, it's a promising omen for widening profit margins. Remember, producer input prices over the past year and a half have grown faster than consumer retail prices, thereby squeezing profit margins. It was largely the energy spike effect. But this could be changing favorably.

As for the pump problem, much of the gasoline price spike is a function of inadequate supplies of reformulated gas mandated by the Environmental Protection Agency during the Clinton years. Think of it as EPA inflation. Or EPA inflationary recession. Or, just try not to think too much about it. This too will pass.

However, with gas pump inflation on the front pages of all the nation's newspapers, and on the front lips of all the cable TV liberal talk show commentators who are desperately trying to bring George Bush's high approval rating down a notch or two, it does appear that fixed-income investors have been shifting out of ten-year Treasuries and into inflation-adjusted TIPS that are protected by offsetting CPI allowance adjustments (on a pre-tax basis). Consequently, since the upturn in gasoline futures last March, ten-year Treasury rates have jumped to 5.40% from 4.75%.

Mirroring this, TIPS prices have rallied and yields have declined. Seeking near-term inflation protection, investors have driven the ten-year TIPS yield from 3.45% a month ago to 3.22% currently. Even more pronounced, the near-term TIPS rate (maturing 7/15/02) has eased to 1.66% from 2.4% last March. As a result, inflation expectations TIPS spreads have widened.

Now, all that said, a goodly part of the drop in TIPS rates also represents the decline of real equity asset values and real economic growth; i.e., the economic slump is causing real rates of return to drop.

So, despite what mainstream economists keep arguing, the fact is that inflation expectations frequently rise when the economy slows. Call it a reverse Phillips curve. Rather than a trade-off between falling unemployment and rising inflation, the two tend to move together. Note that as the economy's 6% real growth rate slumped to 2.7%, the GDP chain price index moved up from 2% to 2.3%.

This is because, in this cycle at least, Federal Reserve overkill tightening policies substantially curtailed investment activity of all types. Spiking interest rates sorely depressed the investment demand for money. Think of it as a tax hike on the usefulness of money.

Along with liquidity deflation, spiking interest rates and a significant rise in the cost of capital eviscerated the supply-side of the economy and launched an investment-led downturn. Even while consumer spending slowed, the production of goods slowed faster. So a reduced volume of money still chased an even greater reduction in the availability of goods. This drove up inflation, if only marginally.

Also, the Fed generated excess money in 1999, especially as they over-accommodated during the run-up to Y2K. Following that, the Fed u-turned and over-deflated in 2000, setting up a shortage of money.

That shortage of money, which still has not yet been fully replenished, has released deflationary price pressures that are temporarily being masked by the gasoline price spike. Today's producer price report, for example, shows that over the past three months the core PPI index has been dead flat, and up only 1.6% during the past twelve months. Meanwhile, also excluding food and energy, the crude level of the PPI -- a proxy for market commodity prices -- has deflated at a 22.7% annual rate over the past three months and a 12.3% pace over the past year.

Additionally, the exchange value of King dollar remains strong and gold has barely climbed off its bottom. At least the Fed's deflationary error did no damage to the external and internal value of money.

Consequently, the outlook for future inflation is benign, most likely less than 2% for the broadest inflation measures. In those circumstances the interest rate outlook is also benign. Ten-year Treasuries should bob around 5%, while hopefully the fed funds rate gets down to 3 1/2% .

As for energy shocks, President Bush got it right at today's news conference. Cut tax-rates immediately to provide energy cost relief and stimulate the economy's long-run growth potential. Build new refining capacity to increase the nation's energy supply.

Let free market prices allocate energy resources for production and conservation. Price controls, however, create scarcity, and scarcity will block the power necessary to fuel the high-tech wired economy. In other words, reduce tax and regulatory barriers to growth wherever they exist. Some might even call it free enterprise.

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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