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Jewish World Review August 6, 2001/ 17 Menachem-Av 5761

Lawrence Kudlow

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Fed surprise and stock market rise -- AGAINST the backdrop of deflating commodity indexes, recessionary purchasing managers reports and a tightening spread between two-year Treasuries and the fed funds rate, a decline in Friday's jobs report sets the stage for an inter-meeting easing move by the Federal Reserve.

Household employment has already dropped five straight months, a clear recessionary signal. If non-farm payrolls reported Friday for the month of July show a third decline in four months, look for the Fed to take immediate action on the funds rate. Despite what they say, in the end the central bank is in fact targeting the economy, desperately trying to head off an official recession.

Private sector real GDP (consumption and investment, excluding government and net exports) has been in recession two straight quarters. Greenspan's testimonies dodged the issue of commodity deflation and recession, but his body language and defensive commentary had sub-conscious recession-fear written all over it.

A bad jobs report will clinch the deal, bring the Fed out of the recession closet and prompt a surprise easing move before the regularly scheduled FOMC meeting on August 21. The move will likely be 25 basis points, but don't rule out 50 bps.

Right now the two-year Treasury is trading around 3.80%, with the funds rate at 3.75%. In the easing stage of the Fed policy cycle, fed funds should be at least 75 basis points below the two-year note. That sets up the possibility of a 3% funds rate before long.

In these circumstances, especially with the latest consumer spending deflator reading of 2.2% annualized over the past three months and a core PCE inflation read of 1.2%, look for 10-year Treasuries to rally on an easing move, unlike prior action in June and May.

What we have here is the possibility of a 4% 10-year and a 3% funds rate shortly after Labor Day. This is the silver lining to an otherwise gloomy economic story. Sometimes bad news can become good news. (Sometimes bad things happen to good people, but that's another essay.)

Another piece of good news. Plunging energy costs have opened up a positive profits spread in the producer price index. Washington economist John Mueller has pointed this out and it's a key stock market point. For the first time in 23 months crude material prices (-2.1% yoy) came in below finished goods prices (2.5%) in the June PPI report. Assuming no energy price spike -- especially from OPEC-driven oil -- this positive profit margin is an early indicator of the long awaited end to the corporate profits recession.

If the 10-year Treasury yield, which is the discount rate to capitalize future corporate profits, does in fact drop another 50-basis points or so, combined with a positive profit margin spread in the PPI, this could trigger a powerful stock market rise.

Using these assumptions, the S&P 500 could rally by 20% this autumn, bringing the index through 1450. That doesn't quite get it back to its 2000 peak, but it's a good beginning. 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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