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The market leap held, but the thirst for cash remains a worry.


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Larry Kudlow

We dodged a bullet yesterday. A threatened run on the banks — on top of the plummeting stock market — was halted.

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Here’s the trouble. While the central bank is creating new money and supplying plenty of liquidity to the economy, the constant drum beat of bankruptcies and celebrity investigations — including most recently the WorldCom bankruptcy and the Citigroup and JPMorgan Chase investigations — along with Harvey Pitt’s August 14 recertification date that could produce scared-to-death CEOs and dropping profits, has generated a risk-aversion-related increase in the demand for cash.

This risk aversion is clearly sweeping through the markets, and bank requests for fresh money from the Federal Reserve are rising. The question is, should the Fed counter this increased demand with a 50 basis-point cut in the key fed funds interest rate that would inject new cash into the pipeline?

The case is not yet open and shut. In quantity terms, the best money measure is the St. Louis Fed’s adjusted monetary base, which year-to-date has grown at about a 10% annual rate. Last year that base grew 8.7%, following a deflationary drop of 2.5% in 2000. Meanwhile, the central bank’s unadjusted balance sheet, referred to as Federal Reserve credit or reserve-bank credit, is currently rising at a near 11% pace, more than twice the rate registered earlier this year.

However, sensitive price indicators show that gold, commodity futures, and the dollar are all down. Liquidity signals are tight.

After rising 10% or more this year, gold and commodities have fallen off their highs, although not by very much. The Commodity Research Bureau (CRB) industrials have leveled off in recent weeks after a 13% gain. Journal of Commerce (JoC) metals are up nearly 12% and JoC industrials are up 15% on balance for the year. The commodity and gold trends all spell economic recovery. Prices are bouncing off steep deflationary lows. Still, a further drop in these key indicators would not be a good sign.

More, bank stocks have been badly battered since mid-June, falling 25% in the S&P index for diversified financials (Citigroup, Fannie Mae, JPMorgan Chase, and Morgan Stanley) and 20% for the bank index (BofA, Wells Fargo, and Wachovia are the three largest of 29 banks). Bank quality spreads in the bond market have widened against the 10-year Treasury note by 43 basis points for JPMorgan and 49 basis points for Citigroup. These are not good signs, either.

The U.S. economy should still pull off 4% non-inflationary growth this year. And while the contractionary impulse from big corporate bankruptcies and investigations is a worrisome economic event, at this present time it is not a conclusive economic event.

Still, the Fed should have its sidearm locked and loaded for a 50 basis point target-rate drop — but it should only act if the markets deteriorate further. This is not to say the central bank should be targeting the stock market. But it should be targeting commodities and other measures of liquidity such as bank stocks and bank-credit. If key cash-demand and liquidity-preference indicators keep falling, and if they are confirmed with another decline in gold and commodities, then surely the Fed should pull the trigger on a liquidity-adding rate cut.

That the president remains clearly off-message isn’t helping the markets either. He is taking pot shots at traders and exchanges, and even commenting on day-to-day market activity. This is ill advised. One friend recently told me that the administration has a regulatory message, not a growth message. Another reminded me of the need to repeal the steel and lumber tariffs. A third pointed out that the administration is making economic decisions based on perceived political needs, and that always leads to bad economic policy.

But sources also tell me that President Bush and senior advisors are catching their breath and realizing they need to get back on message — which was the optimistic growth message of 2000 and 2001. It would also be nice to hear some new thinking on regulatory and tax reform that would promote growth and offset the negative effects of higher regulatory costs for accounting, securities, and corporate governance.

Yesterday, the market stayed up — marking its largest one-day gain in more than a decade and a half — and we dodged a bullet. One day at a time is the best way to get through this financial crisis — and just about everything else in life, too.



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