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Jewish World Review Nov. 27, 2001/ 12 Kislev, 5762

Lawrence Kudlow

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First Quarter Recovery? -- THE consensus of economic forecasters anticipate economic recovery in next year's second half. Bolder forecasters believe recovery evidence could surface in next year's second quarter.

But the recent upturn in Treasury rates suggests that recovery could surface as early as the first quarter. That's right, the first quarter.

In the past two weeks both nominal and inflation-adjusted Treasury rates have reversed direction. After falling for over a year, Treasury rates have suddenly headed upwards.

Changes in the direction of interest rates often signal turning points in the economy. When rates are falling, people tend to postpone spending and investing decisions in search of the interest rate bottom. Holding back until financing costs have hit their low point, people have an incentive to defer economic activity. This deferral effect coincides with economic slumps. That's pretty much been the story for the U.S. economy over the past eighteen months or so.

When rates turn up, however, people frequently accelerate their economic activity. This acceleration effect comes from the incentive to beat higher financing costs that are likely to occur in the future.

It is this acceleration effect, which could be starting to happen right now, that may be signaling a turning point in the economy. Real interest rates in the government securities market have suddenly jumped between 35 and 100 basis points, while market rates have increased roughly 65 basis points across-the-board.

Interest rates are forward-looking indicators; much better forecasting guides than backward-looking GDP or other government statistical releases. Treasury rates in particular are especially sensitive to shifts in inflation, taxes and economic growth.

A forecasting model using the five-year inflation-protected Treasury security (TIPS), which matures in July 2002, is actually predicting an annual rate of 3.8% economic growth in both the first and second quarters of next year, following a 2% decline in this year's fourth quarter. This model uses the five-year TIP as a coincident indicator of real GDP growth. Statistically it has a high correlation of 0.88, with a strong explanatory power R-squared of 0.77.

Of course the model may be irrationally exuberant, overstating the recovery case. But even if first quarter growth comes in at 2%, that would be a surprise. Stronger-than-expected and sooner-than-expected economic growth implies an earlier-than-expected rebound in corporate profits.

That is exactly what the forward-looking stock market could be telling us. >From the September 21 low, the S&P 500 is up nearly 20%. The leading sectors are classic cyclical recovery growth areas: technology (40%), consumer cyclicals (29%), capital goods (27%), transportations (26%), basic materials (23%), and financials (19%).

While Congress has not yet passed its so-called stimulus package, there's a lot of stimulus emerging from our dynamic and resilient economy. Price-cutting is occurring all over the place: lower financing rates, cheaper autos, heavy discounting by retailers, clothing stores and various home furnishings, all manner of technology-related price drops, and energy price declines.

Gasoline price drops are a major stimulant. By some estimates every 10 cent decline in pump prices increases consumer disposable income by $15 billion. Since May gas prices have fallen about 50 cents. Do the math: it's a $75 billion stimulus package. And don't forget the big price drops in electricity and natural gas, which have contributed to positive profit margins over the past five months for good-producing firms.

Add to that the efforts of the Federal Reserve, which has been a busy little beaver this year, especially in the last two months since 9/11. The basic liquidity measure controlled by the Fed, the monetary base, has expanded by 9% year-to-date. Last year it deflated by 3%. Along with declining interest rates, that's a big turnaround in monetary policy from excessive restraint to substantial stimulus. With the two-year Treasury now yielding 100 basis points above the fed funds rate, there is no need for additional central bank easing measures.

As yet there is absolutely no evidence of recovery in the business sector. Industrial production and business equipment investment are still falling. That's why accelerated depreciation and small business tax-cuts (nearly one-third of personal taxpayers are small businesses) are still necessary. You can't consume what you don't produce. True consumer purchasing power always stems from investment and production.

However, tax cuts are surely coming before yearend. And another tax cut-like effect is developing from the good news on the war front in Afghanistan. As the noose tightens, the war uncertainty tax declines. As people at home feel more comfortable about domestic security, the war tax effect falls even more.

So while business is still lagging, the interest rate signal suggests that better times are coming. And they may be coming a lot sooner than folks think.

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