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Jewish World Review Oct. 11, 2001/24 Tishrei, 5762

Lawrence Kudlow

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Consumer Reports

Second Differences makes a difference -- WHEN the Fed started cutting interest rates last winter, most of the investment gurus on Wall Street predicted a rapid recovery for the stock market. Declining interest rates would stimulate the economy and revive corporate profits, it was argued. Buy now signs were posted everywhere.

Unfortunately for investors, the story went sour. As we know, it's been a rotten year in the stock market. So now a lot of commentators are thinking that maybe this time it will be different. Meaning, perhaps Fed rate-cutting stimulus may not work.

But now is not the time to despair. Just as overly exuberant gurus were wrong in thinking that Fed rate-hiking eighteen months ago wouldn't depress the market, they shouldn't think that central bank rate cutting won't work now to revive it. It will. But these things take time, on the way down and on the way up.

The problem last winter was a misread of the relationship between stocks and short-term interest rates. Going back to examine the last four recession episodes, we found that in the first instance declining short-term interest rates are a big negative for the stock market.

In particular, careful charting of changes in the 91-day Treasury bill rate shows it to be an important coincident indicator of the stock market for a little less than a year. Looking back at the last four recession cycles, we find that Treasury bill rates and the S&P 500 index declined together for an average of 45 weeks. Stocks, profits, rates and economic activity fall together.

This historical exercise shows that stocks don't recover until short rates stabilize or even rebound a bit. Using the four recessions between 1973 and 1990, the data suggests that a stock market revival occurs on average fourteen weeks before Treasury bills stabilize.

Right now interest rate futures markets are predicting a bottom in short rates sometime in January or February of next year, somewhere between 25 and 50 basis points below today's level (which is 2.5% on fed funds, and 2.25% on Treasury bills).

So if stocks historically turn up three to four months ahead of the bottom in short rates, we are entering the turning

zone right now. That suggests that the current stock ma

rket rally is for real. And a model we use suggests the market could turn up by as much as 40% to 50% on the S&P500 in the next year. This would actually be a bit more than the average recovery of slightly less than 40%.

Our model uses the change in the change of the 91-day Treasury bill rate, which economists call second differences. Because the Fed has been lowering its policy target rate very quickly this year, much more quickly than in past easing episodes, this means that subtracting a rapidly declining rate from a declining rate leads to a positive rate of change. Got that? How about: two negatives equal a positive.

If Washington delivers meaningful tax-rate reduction to boost investment and work incentives, all the

better for this positive stock market scenario. If the war against terrorism goes well at home and abroad, all the better for an even more positive stock market scenario.

But the key point is that after a year of sharp interest rate declines, especially at the short-end, or what we call the liquidity end of the Treasury interest rate structure, the table is set for a sizable stock market recovery. And the models also show that a market recovery will be just the appetizer. With any luck at all, the main course next year be an economic growth rebound of roughly 3.5% at an annual rate during the last three quarters of the year.

However, the average first recovery year normally registers a 5.4% growth rate. This is why we still need a strong tax-cut package. The Fed looks to be finally doing its job. But only across-the-board tax-rate reduction will re-energize incentives to maximize the rate of investment, production, employment and growth.

With monetary base growth rising significantly, nominal GDP or total spending in the economy should expand by 5% or more next year. Within this nominal framework, the trick for policymakers is to open the door to a positive mix of lower inflation and higher real growth. Supply-side tax-cuts can raise the growth of real output and reduce the inflation rate. At the margin, more investment and production will absorb the available money supply, bringing inflation down.

So the stakes are high for President Bush and his economics team. With a 90% approval rating, the president has an opportunity to work with people such as Dick Armey, Phil Gramm and Zell Miller to craft a strong pro-growth tax-cut plan. If so, then next year's economy could surprise a lot of people. Four percent economic growth could co-exist with 1% or less inflation. This kind of prosperity revival at home will finance the war against terrorism and then some. This kind of prosperity will raise the American spirit.

And that's exactly what the current stock market rally is hoping for.

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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©2001, Lawrence Kudlow