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Liquid Measures
Cushioning the economic decline.


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Larry Kudlow

The Fed surprised us pleasantly Tuesday by pumping in $8.5 billion worth of overnight cash. Why did Greenspan & Co. do it? Perhaps to calm financial market anxieties over the bombing attacks in Afghanistan, or perhaps to cushion the sinking economy. In any event, Fed RP (Repurchase Agreement) actions through October 9 supplied $38 billion compared to the $29.5 billion liquidity add when we last saw them on October 4.

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For the banking week of October 3, free reserves (excess minus borrowed) tallied $2.2 billion. While this is well below the $32 billion free reserve position registered right after September 11, it’s $1.1 billion above the average seen during the first eight months of the year. The central bank should keep force-feeding the financial system with plenty of extra money. Commodity indexes are still slipping, and gold is barely holding around $290.

The ten-year TIPS spread is forecasting less than 1.5% CPI inflation. With oil prices coming down (three cheers for Vladimir Putin), price indexes are likely to show minus signs in the months ahead. So, inflation is simply not a problem; indeed, deflationary pressures made more intense by a spreading credit crunch is the real worry. The Fed cannot directly solve the shrinking net-worth problem of American businesses, but it can certainly provide plenty of excess liquidity to cushion the economic decline.

Futures markets are still predicting a 2% funds rate in January. So Greenspan & Co. (drip, drip, drip) are getting close to the end. The stock market tends to turn up a few months before short-term interest rates and the economy stabilize — meaning, we are getting close. Hence, the mini stock-market upturn in recent weeks looks to be real.

Also favoring stock-market appreciation, the effective tax-rate on real capital gains is coming down as a result of lower inflation. The three-month change in the personal spending deflator has downshifted to 0.3% at an annual rate from 3.6% last winter. Consequently, the inflation tax-adjusted capital-gains tax rate is declining to 21.7% from 40.5%, even without any help from the deadhead class-warriors in Washington.

This inflation tax-cut on capital gains means that investors keep 78.3 cents on the extra dollar gained, a 31.5% incentive-reward increase from the high inflation return of 40.5%. All things the same, this implies a potential stock market increase of roughly 30%.

Happy hunting and keep the faith.



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