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A Hands-Off Recovery
Rates are staying put in this non-inflationary environment.


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Larry Kudlow

There they go again. Those nutty bond traders believe that Alan Greenspan — after cutting interest rates a whopping 11 times in 2001 — is going to raise the key fed funds rate a full point by year-end. Now, don’t get me wrong. These bond traders are good God-fearing traditional-family-values people. Yet they are completely panicked over the first faint signs of economic recovery. To the traders, recovery means a return to inflation. And when Greenspan even smells inflation, as we know, he goes into rate-raising mode.

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But this scenario does not make sense. There is absolutely no inflation. In fact, price indexes are still declining in the aftermath of the Fed’s scorched-earth policies over the past few years (remember, while Greenspan cut rates 11 times last year, he raised them 9 times between mid-1999 and mid-2000 to keep the economy from behaving too vibrantly).

Recent productivity data is also telling a more optimistic story than your going to get from the bond traders. There has been an unusual increase in output per hours worked during the recession. This could lead to a 4% or 5% gain in productivity, which would wipe out any potential inflationary developments. The rapid pace of the technology advance, which only makes the economy less prone to unnecessary price rises, is also an occasion to smile.

Want to smile even wider? There may be two big surprises in the year-ahead economy. First, there have been significant liquidity increases from the Fed since Sept. 11, and this newly-created money is going to change hands, circulate between businesses and consumers, and raise economy-wide investment and spending. Second, zero inflation could mean that virtually all of the rise in spending will translate into real growth.

Which leads us back to the Fed. How will Greenspan react to a strong growth scenario? Will he panic, too, and take us back to the rate-hiking days of 2000? His best response would be to do nothing. Just let the free-market private economy snap back on its own, without any meddling, fine-tuning, or tinkering. And if this zero-inflation recovery lapses into an inflationist recovery — despite all current evidence to the contrary — then the Fed could take remedial action. But that’s not likely. This no-inflation recovery is going to pan out, and the central bank should keep its hands to itself.

The historical record of the past four post-recession episodes even suggests that interest rates are more likely to fall, not rise, during the first fifteen months of recovery. The exception was in the early 1980s, when then-Fed chairman Paul Volcker unnecessarily raised rates. But lower tax-rates from President Reagan actually reduced inflation by creating more goods to absorb the money in the system. Fortunately, Volcker recanted by dropping rates soon afterward.

And if we compare the Reagan-Volcker episode to this current recovery outlook, personal tax-rates are also coming down, although slowly. Lower taxes, and the tax-cut effect from declining inflation, means more available dollars for investment. This will again lead to the creation of more goods that will absorb the new volume of money in the system, without inflation.

Once the law enforcement agencies straighten out the Enron-Arthur Andersen mess with appropriate penalties and more conservative accounting standards and corporate-disclosure guidelines, the forces of economic recovery should drive the stock markets considerably higher. Just as economic growth and profits will be surprisingly strong, interest rates are likely to be surprisingly stable.

There’s a lot of pessimism around right now. But it will soon pass. President Bush is on the right track with the war on terrorism, and the economy is on the right path for a non-inflationary recovery. Optimism will soon gain the upper hand. Indeed, optimism always defeats pessimism. Hold that thought, America.



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