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Jewish World Review Oct. 1, 2001/14 Tishrei, 5762

Lawrence Kudlow

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Moving on the Supply-Side

http://www.jewishworldreview.com -- BOTH stock and bond prices are rallying in response to fiscal and monetary policy changes in the direction of growth. Washington is moving towards broad-based tax-cuts and the Fed is adding more liquidity. Amidst an understandable degree of chaos and confusion in the new world of war and recession, at the moment it looks like a supply-side policy mix is emerging. Let's keep our fingers crossed.

A careful scrub of the Federal Reserve's overnight liquidity-supplying operations shows a central bank shift to greater stimulus in recent days. Though Mr. Greenspan has been telling fiscal policymakers on Capitol Hill to go slow, he is changing his tune on money matters inside the FOMC.

Overnight repurchase actions have increased from a $24 billion low point on September 21 to nearly $42 billion over the September 28 weekend. Prior to that the Fed had significantly reduced its cash injections from $81 billion down to the aforementioned $24 billion.

Confirming the increase in temporary reserve supplies, most Treasury market rates have been declining, especially at the short-end. Three-month Treasury bills are trading around 2.35%, with two-year notes just above 2.80%. Ten-year paper has shifted down toward 41/2 %. These are all near 40-year lows.

Also confirming the pick-up in liquidity, the gold price has moved up to the mid-$290s range from $271 the day before the terrorist bombing. Some of the gold rise can be attributed to financial fears and worldwide uncertainty. However, the gold rally is surely indicative of the increase in liquidity provided by the Fed. Partially offsetting the intense deflationary policies of the last eighteen months, these Fed liquidity injections are being well received by the stock market.

Added to this, growth proponents imbedded in the stock market are undoubtedly pleased that Washington is moving towards a much stronger tax-cut package that will include capital gains, business relief and quite possibly an acceleration of the original personal tax-cut package. In classic supply-side terms, economic growth incentives from lower marginal tax-rates need to be accommodated in the current deflationary environment with greater liquidity doses from the Fed. At the moment, though both money and tax policies are still unclear, there is good movement in the right direction.

The Fed still has more work to do, however. When the government bank unlocked its fed funds policy target rate last week, market forces moved it closer to 2% than the official 3% level. Also, the bottom end of the yield curve, which I call the liquidity end of the curve, is still inverted.

Overnight money should be cheaper than 91-day money or two-year money. With T-bills around 2.35%, and two-year notes around 2.8%, the best thing the Fed could do on Tuesday is drop its target rate to 2%.

At the same time, they should make their so-called temporary reserve additions permanent reserve additions. Liquidity adding is much more important than interest rate targeting.

Broad commodity indexes are still in decline; only the precious metals sector has shown any life signs. Declining energy prices appear to be leading other sectors down. Metals are very weak. The inflation-forecasting TIPS spread is just 145 basis points. This is really projecting a reported inflation rate of about 1%, essentially price stability given the flaws in the government's various price indexes.

Twelve-month growth of the Fed's monetary base has increased to 101/2 %, and in all likelihood the central bank should maintain this high degree of liquidity provision for quite some time. When financial and commodity price indicators signal an overdose of liquidity, the Fed can simply take it out. My hunch is we are a long way from that point.

Right now we've got a war to win and a recession to conquer. Growth policies at home to solve the economic slump will form a strong foundation to wipe the terrorist evil-doers off the map of history. Naysayers beware. Faith in American freedom and democracy is the wisdom of the ages.


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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