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Jewish World Review Sept. 16, 1999 /6 Tishrei, 5760

Lawrence Kudlow

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Bad Dollar Logic -- JUST BACK FROM VACATION, I've come to realize that my interest rate worry beads over the next month or two are not centered on the economy, wages or inflation. All that looks just fine.

Instead, I have a question for the Fed: When will policymakers come to realize that repeated attacks on economic growth and the stock market are really attacks on the U.S. dollar? A cheaper dollar is exactly what our technology-driven information economy does not need. A cheaper dollar will drive up interest rates and inflation, throwing a big monkey wrench into prosperity. Who needs it?

While the Internet economy has taken off, King Dollar's rising purchasing power in recent years has been the flywheel holding inflation in check. Why would the central bank tamper with this? Phillips curvers who believe that strong growth and jobs cause more rapid inflation have been wrong. Once again. Even Laurence Meyer is beginning to recant. Mainly because of the dollar.

At the New York Economics Club, Treasury Secretary Lawrence Summers had the story right when he stated that "a strong currency is in our national interest . . . it helps to hold down inflationary pressures and keep interest rates low." Amen to that.

But, since the Fed began tightening in late June, fed funds and discount rate hikes have actually weakened the dollar by roughly 5%. This runs counter to the conventional wisdom that higher rates bolster a currency. Now, currency markets are saying that the new Fed policy of less growth and lower investment returns make the currency less attractive. Is the Fed paying attention to this important market message?

Of course, there's still no dollar panic. The dollar index is 25% above its 1995 low. Importantly, when measured in terms of gold, money value looks strong in Japan, Europe and the U.S. Dollar gold has lost 12% this year, while Euroland gold has dropped 21% and yen gold 22%. So there's no global inflation in the making.

Also, the rise in the Japanese yen is mostly a function of an improved economic growth outlook for that country, following across-the-board marginal tax-rate reductions implemented last April. It's yen strength more than dollar weakness. Anticipating higher economic returns, the yen's real exchange rate has appreciated. The Nikkei Dow has jumped 28% this year, by far the best performing big country stock market.

All that said, I still worry that the Fed's loose lips could still sink the U.S. economic ship. If the anti-growth and anti-stock market mantra continues, then sooner or later global investors will come to believe that the central bank will in fact substantially reduce U.S. stock market and economic returns.

If so, then investors will switch out of dollars into other currencies with higher expected returns -- presumably where the local central bank is not deliberately thwarting economic growth. This could be Japan, or other parts of Asia, or perhaps Europe, or Mexico, or wherever.

But the key point is that reduced demand for dollar balances and dollar-based financial assets poses an inflationary threat. If a weakened economy lowers dollar demand, then the existing dollar supply becomes excessive. Too much money chasing too few goods.

So I now think that the crucible for near-term Fed policy is not wages, or unemployment, or third quarter growth, but the dollar. If the Fed persists in attacking prosperity, they will be hoisted on their own petard. Think of it as self-destructive behavior. Should the dollar index drop substantially more, say 10%, then much more serious interest rate tightening will be required.

There are other straws in the wind that suggest dollar demand is slipping. Over the past six months M2 growth, for example, has slowed to 5%. Its prior peak in January was 10%. This probably reflects a fall-off in transactions demand, which could be signaling a slowdown in the economy. But if international investors are moving out of dollars, this would also contribute to a softening in M2 growth.

The CRB-Bridge commodity index has gradually moved up from the low 180s to above 200. Of course, this follows two years of deflation. At 200, the CRB is still 23% below its 1996 peak of 265. However, I can't help but think that recent dollar exchange rate softening is linked to the CRB rebound. Keep an eye on this.

So far the Fed's anti-growth campaign has produced only a few light taps on the monetary brake. No real damage has been done. But it all seems so unnecessary.

Even worse than the Fed's recent tightening moves is the anti-prosperity and anti-wealth thinking behind the moves. Don't they realize that low inflation is driving the economy and the stock market higher? But more jobs and higher share prices don't then turn around and cause higher inflation. This latter point, which seems to characterize current Fed thinking, creates a dizzying image of the dog that is constantly chasing its own tail.

But neither the economy, nor most dogs, behave this way.

Stock market wealth creation has generated an investment boom, not over-consumption. With high price-earnings multiples and low earnings yields, rock-bottom financing rates permit companies to sell shares, raise new capital and upgrade business equipment, including new information technologies.

So it's much cheaper for firms to grow future earnings and dividends, thereby adding to shareholder value. Affordable capital has increased the investment share of the economy from 12% to 18%, while the consumption share has moved only slightly, from 67% to 69%. Why would the Fed oppose this? More capital leads to higher productivity. Isn't this what we want?

An old friend who is a retired bank supervision officer from the New York Fed called up the other day. He is very unhappy with the FOMC attacks on growth and stocks, calling it "Fed meglomania, this business of making pronouncements on everything. It's entirely inappropriate. They should have a much lower profile."

I, of course, would never utter such a harsh criticism. It would be disrespectful. But, surely a Fed-free bond market would have Treasury yields below 5% instead of above 6%. And the stock market would be pushing through 12,000 on its way to 15,000 before long. With 3 1/2% growth and virtually zero inflation. And a strong dollar, used as money all over the world.

That's the Internet economy, which will ultimately triumph over government fine-tuning. Sometimes my optimistic vision is clearer for the next five years than the next five weeks. So it goes. 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.


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08/26/99: Let Prices Rule
08/19/99: Blame OPEC, Not Growth

©1999, Lawrence Kudlow