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Jewish World Review Aug. 26, 1999 /14 Elul, 5759

Lawrence Kudlow

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Let Prices Rule --
LET'S BE VERY CLEAR about the Fed's credit policy decision on Tuesday, August 24: the only intellectual justification for a tightening move is to limit the growth of employment, wages and the economy.

And, in my judgement, this is bad thinking. Very bad thinking. The greatest nation on the planet should not be conducting monetary policy to punish successful wage earners or wealth creators. This Malthusian pessimism is unseemly and undignified.

The alleged Phillips curve trade-off between unemployment and inflation is a theoretical model in search of corroborative evidence. But there ain't none. The notion that too many people working, producing and prospering is a bad thing is, itself, a very bad thing.

In recent days I have watched a parade of economists on CNBC who report that there is no evidence of rising inflation. Yet they still assert that the Fed will raise the overnight funds rate to 5 1/4% from 5% "because the economy is too strong," or "wages are rising too fast." Shame on the economics profession. Perfectly intelligent people pursuing the wrong model. Or, they are merely parroting the Fed line.

Yet the Fed might change its line if enough people protest it. Argue it. Just as Steve Forbes and Dan Quayle did in the Iowa straw vote. Just as supply-siders such as Jack Kemp, Art Laffer, Victor Canto, Larry Hunter, Mark Miles, Richard Salsman, David Ranson, Jeff Bell, John Mueller, Ray Keating, John Ryding, Brian Wesbury, Wayne Angell, the Wall Street Journal editorial page and myself have done. Or non-supply-siders such as Fred Bergsten, Larry Chimerine and Bill Wolman.

Message to Fed: target prices, not the economy. Stable prices will generate strong growth, low unemployment and declining interest rates, if the central bank does not interfere. Our prosperous free-market information economy is self-regulating; it does not require constant government fine-tuning. In fact, history shows clearly that fine-tuning is an economic destabilizer, not a prosperity-inducer.

The most important monetary value price is gold, the mother of all inflation barometers. Over the past three years gold has dropped 33%, as broad inflation measures have slipped from 3% to slightly above 1%. During the past year gold has lost another 10% of its value. This suggests that inflation during the next twelve months will fall below 1%.

If you fret that gold has been depressed by central bank gold sales, then look at a bundle of precious metals (gold, silver, platinum). This CRB sub-index has dropped about 20%. No central banks are selling silver and platinum. So the message is the same as gold: disinflation.

How about the overall CRB index of seventeen commodities? Including energy, industrial metals, precious metals and farm commodities, the CRB is down about 25% over the past three years. Its industrial metals sub-index has lost 28%. Excluding its over-weighted oil component, the Goldman Sachs commodity index is off 34%. Deflation, not inflation, is the message.

Or take the dollar. Today's dollar isn't weak, as so many commentators argue. Instead, in relation to domestic commodities, the dollar is very strong. What's really happening is that the Japanese yen is strengthening.

This is because marginal tax-rate reduction is boosting the outlook for real economic returns in Japan. This, in turn, raises the yen's real exchange rate. It is corroborated by the Nikkei Dow index, which has outperformed all G-7 stock markets this year. Exactly the same effect occurred in the Reagan Eighties, when supply-side tax cuts caused the dollar exchange rate, the stock market and the economy to soar.

Meanwhile, at 100, today's dollar index remains high, about 20% above its early 1995 cyclical low, and up 6% year-to-date. The dollar is strong in relation to its two largest trading partners, Canada and Mexico. Though below its peak, the dollar remains strong relative to the overly taxed and regulated Euro.

Finally, Treasury bond market spreads provide no hint of rising future inflation. The gap between 10-year notes and 3-month bills is a normal 120 basis points, only slightly above the average 80 basis point spread of the past three years (during which time the consumer spending deflator averaged a puny 1.5% per year). Sure, today's yield differential is 100 basis points above the late 1998 level, but that was a rush-to-quality deflationary crisis resulting from Asia, Russia, Brazil and Long-Term Capital.

Same story for the inflation-indexed 10-year note. The current spread between TIPS and the 10-year note is about 170 basis points, about one percentage point wider than late 1998. However, during the past three years this spread has averaged just over 200 basis points. So there's not much going on here.

Even the rise in 30-year Treasury rates to 6% today from 4 3/4% last autumn should not be misinterpreted. Risk-averse global investors rushed to quality then, causing a temporary undershoot in yields, especially real yields. But the resilient U.S. economy continued to expand at a 4% trend rate, and the global financial crisis eased. So the long bond's real interest rate component rebounded, pushing the nominal yield back to 6%.

Here's an interesting thought. Over the past three years the 30-year Treasury rate has averaged 6.14%. During this period, average real economic growth posted a 4% annual pace, with 1.5% yearly inflation. Meanwhile, the stock market nearly doubled, rising by 5,357 Dow points to today's 11,000. So, in today's healthy economic environment, a 6% long bond -- very low by historical standards -- is not an obstacle to prosperity or a rising stock market.

All these market price rule indicators -- gold, commodities, the dollar index and the bond market -- are pointing to near-zero inflation and overall price stability. Hence there is no need for Fed tightening.

Inflation is a monetary problem caused by a decline in the dollar's purchasing power, not by 4% economic growth. Inflation is caused by excess money creation relative to the global demand for money, not by a 4.3% unemployment rate. Inflation is caused by too many dollars chasing too few goods, not by a highly productive technology-enhanced workforce being rewarded by higher salaries and living standards.

The price rule indicators are very clear: dollar purchasing power is strong and inflation is nil.

Boston economist Mark Miles recently e-mailed me this note: "The only thing we have to fear is the Fed itself." This, of course, is a paraphrase of Franklin Roosevelt. It's an important thought. Well worth pondering. Will the Fed stick to their outmoded models and unseemly thinking? Do they realize that increasingly tighter money will bury China, Brazil and Russia. Or will they provide real monetary leadership for the U.S. and the global economy?

During the Greenspan years, whenever he departs from a price rule approach, he doesn't stay off it for long. Right now, he's on the wrong road. But I don't expect him to remain on the Phillips curve path. That is why I'm doubting a one-quarter of a percent rate hike on Tuesday. If I'm wrong on this, I don't think there's more coming after that.

With a strong dollar and weak gold, this is surely not the 1970s, not even the late 1980s, nor even 1994. My outlook suggests only 1% future inflation and a 5% to 5 1/2% long bond over the next year. Economic growth should range around 3% or slightly less. Profits will remain healthy.

Tax-rate cuts are in the air. Electoral change is coming to the White House. Welfare is down, the Laffer curve is up. Malthus, Marx and Keynes are losing; Hayek, von Mises and Friedman are winning. The Schumpeterian long wave of technology is intact. The world won't turn on a one-quarter fed funds rate change. Keep the faith. Faith is the spirit.

JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


08/19/99: Blame OPEC, Not Growth

©1999, Lawrence Kudlow