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We’re in The Money
Milton Friedman's M2 could be signaling a big economic pick-up.


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Larry Kudlow

There is a new plus that is more powerful than temporary tax rebates and much healthier than outsized federal spending increases. The broad U.S. money supply has started to pick up significant steam in recent weeks, leading to an 11% annualized growth in the just ended third quarter. It’s the fastest money pace in a year.

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Specifically, Milton Friedman’s M2 — the money measure that takes into account currency, checking accounts, money market funds, and savings accounts — could be signaling a big economic pick-up next year, a very bullish development for stocks. While M2 is certainly not an infallible indicator of economic trends, historically it links to current and future changes in national income. So it is worth watching.

M2 correctly warned last winter and spring that economic trends were slowing down in 2002 after a notable economic rebound in late 2001. The surprising post-9/11 economic recovery was accompanied by a near-25% stock market rally that completely contradicted wartime pessimism. This was preceded by a doubling of M2 growth — it moved up to 12% by year-end from 6% twelve months earlier.

Of course, the Fed helped matters along by cutting interest rates eleven times last year, thus growing the supply of high-powered cash by about 12% (not including the Fed’s significant 9/11 money-adding operations).

This year, however, monetary trends turned down. Monetary-base growth, which fuels M2 growth (in Friedman theory), trended down to 5% or 6% by the middle of 2002. Presently it is growing about 7%.

Meanwhile, M2 growth, which in some sense measures the use of Fed cash, tumbled all the way to 2.5% by early June this year from 12% in the late fourth quarter of 2001. In general terms, this surprising drop seemed to carry the stock market down with it. Earnings estimates were brought down. And new gloom over future economic growth intensified.

Yet since bottoming around mid-year, money has turned up significantly. This is a very good sign. One wonders if the stock market bottom of late July is somehow picking up the upturn of M2 growth.

Tax-rates are a bigger economic influence than money over the longer term, especially with respect to incentivizing output, productivity, and investment. But money is key in the shorter run. And it has definitely become more generous.

So, if this positive money-reading is in fact accurate, then we are headed for a substantial stock-market rise that will not be less than 15% or 20% and could be as much as 40% among the major averages. Indeed, a pre-election stock rally may have already begun.

Whether Friedman M2 is a leading indicator, or a coincident indicator, or a little of both, its recent recovery spells good news. It is just that simple.

But we haven’t yet seen a clear confirmation of monetary stimulus from solid gains in gold and industrial metals. Nor have we seen clear liquidity-adding signs in Treasury market rates, or corporate bond market evidence that profits and credit quality are definitely on the mend.

For these reasons the Fed should still pump more cash into the financial system with another interest rate cut. This would insure that Friedman M2 growth stays aloft in the months ahead.

Unfortunately, neither President Bush nor Democratic Congressional leaders have proposed an investor tax-cut package to boost stock values by relieving the double-taxation burden on dividends. However, Ways & Means chair Bill Thomas has proposed a $5000 increase in the investment loss deduction, along with a 75-year old age limit for 401(k) retirement redemptions and an acceleration in supersaver contribution increases. These are good ideas that could pass the House, but will not get through the Senate.

So that leaves the money story. Money matters. It matters for consumer activity, investment, and the growth of this economy. Couple this money surge with the strong bi-partisan Iraq war resolution that sends the right signals to our U.N. friends and our Mideast terrorist enemies and the picture looks to brighten substantially. The economy is not as strong as it should be, but it’s still better than naysayers would have us believe. Nonetheless, incumbents better beware in the mid-term elections. The investor class is not a happy camper.



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