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My Optimism: Defined
The data remind us to keep the faith.


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Larry Kudlow

Market price indicators continue to point toward economic recovery and additional stock-market gains next year. In particular, rising real interest rates, an upward-sloping Treasury curve, a stable dollar, and bottoming commodity indexes imply 3.5% real economic growth from the end of 2001 to the end of 2002 — with only 1% inflation.

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Corporate profits on a national accounts basis (GDP) could rise at least 10%, while S&P earnings could run upwards of 30%. Since the September 21 bottom, the S&P 500 stock index has appreciated around 17%, and looks to rise by about 20% more. Thus far, the sector signals from the S&P are pure recovery: technology (41%), consumer cyclicals (30%), transportations (27%), basic materials (25%), and financials (18%).

War news in the global battle against terrorism continues to go well. The al Qaeda terrorist organization has been severely crippled in Afghanistan, with more to come. Bin Laden will soon be terminated. Israeli retaliation against Hamas terrorism has temporarily unsettled world stock markets, but the message here is positive: terrorism will be defeated and freedom will thrive. Whatever it takes, freedom and democracy will prevail. Make that freedom, democracy, and prosperity. It is the wisdom of the ages.

Domestic politics has taken a nastier turn, regrettably, as President Bush’s proposals to reduce tax rates, expand energy production, and broaden global free trade are being held up by the Senate Democratic leadership. If the president pushes hard for his agenda, he can win. More will be revealed on these issues, but passage of any or all will enhance the outlook for economic growth. Pro-growth policies are essential ingredients to financing and winning the war.

There are still unresolved issues inside the U.S. economy, such as a lingering credit crunch for small businesses and a still-absent flow of high-risk venture capital for innovative business start-ups and technology breakthroughs. A painful recession in business output, equipment, and profits suggests that capital spending will come on slowly during the recovery. But depleted inventories will be replaced and modernized technology equipment will be purchased.

Meanwhile, sinking energy costs improve producer profit margins and increase consumer disposable income. Widespread price discounts are another tax-cut. Near-zero inflation lowers the effective capital-gains tax and anchors historically low interest rates.

As a sleeper issue, look for military-related spending and production to add torque to the recovery. In this sense, old-economy activity remains important. Add to that, however, a new-economy technology piece to the defense story: cave-invading intelligence needs and bombing missions will invoke Schumpeterian gales of creative destruction. Amen.

The biggest uncertainty — apart from the war — will likely be the future course of Federal Reserve policy. If Greenspan & Co. return to a market price rule approach, then recovery-related interest-rate increases will stem largely from a growth-induced rise in real rates; nothing to block either the stock market advance or the cyclical upturn.

However, if the Fed returns to its Phillips curve approach of targeting economic growth, then interest-rate increases will be more punitive. Right now, interest rate futures markets are anticipating a roughly 150-basis-point rise in the overnight fed funds policy target. Hopefully this is an overreaction to a worst-case Fed scenario. All political and economic hell will break loose if the Fed stifles recovery.

My advice: take the interest-rate story one day at a time. A year from now, 10-year Treasuries ought to land around 5%, with the fed funds rate about 2%. In other words, if it ain’t broke, don’t fix it.

But, of course, forecast updates will be early and often. Based on the supply-side view that incentives matter, inflation is caused by unstable money, not growth, and markets are better barometers of policy and the economy than Phillips curves.

The terrorist bombings of September 11 have changed the world. But it is a change for the better. No hand-wringing here; only optimism and hope. Down through the ages, optimism and faith sustain us. Keep the faith, faith is the best spirit.



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