It’s Spelled M-O-N-E-Y
The current rate of liquidity expansion is inadequate.


Larry Kudlow

This week’s somewhat confusing action by the Federal Reserve — a plain vanilla, inside-the-box quarter-point cut of the overnight interest rate — left stock and bond markets equally confused.

On Wednesday, the day the Fed announced it had lowered the federal funds rate by 25 basis points to 1 percent, stocks fell. But on Thursday the equity market scratched its head and recovered some of the losses.

Treasury bonds, meanwhile, got whacked. The bellwether 10-year note climbed all the way to a yield of 3½ percent. Only ten days ago it was about 3 percent. Some of this sell-off reflects a disappointment that the Fed did not launch a shock-and-awe liquidity-adding program, like the one Alan Greenspan recently floated when he said the central bank could start to purchase 10-year bonds. This policy move would have given the Fed one more way to pump new cash into the pipeline. Call it another missed opportunity by our central bankers.

What we needed from the Fed this week was shock-and-awe-level accommodation — in the form of a 50-basis-point cut of the fed funds rate or a liquidity-adding policy shift away from the Fed’s ongoing interest-rate targeting. We didn’t get it, but the fact remains that a 25-basis-point cut of the funds rate represents a 20 percent easing move.

Is that enough? Doesn’t look like it.

Overall monetary trends remain disappointing, with no clear sign that we are safely in reflationary territory. The monetary base — the basic money-supply measure controlled by the Fed through its net purchases of U.S. Treasury securities — has increased over the past two months by about 5½ percent at an annual rate. But that’s way down from the 11 percent base-money growth we were enjoying in the two months ending in April.

This current rate of liquidity expansion is inadequate — and it may help to explain recent slumps in the price of gold, the most liquidity-sensitive market indicator. Gold has slumped to $344 today from $380 a few months ago. Industrial metals have also stalled in commodity land.

Transaction demands in a rising economy, including powerful new investment tax incentives from Washington and a new spate of Wall Street deal-making activity in software, biotech, entertainment media, and financials, must be fully accommodated by the Fed. But in the last month, base money created by the Fed has inexplicably flattened out — exactly the opposite of what one might expect from a deflation-fighting central bank.

Perhaps the Fed’s latest rate cut will eventually be associated with a significant liquidity buildup. Perhaps there will be a return to rapid monetary-base growth. But these are not certainties. Once again, the Fed has left everyone guessing.

Oddly, coverage of the Fed’s latest move in the three leading newspapers — the Wall Street Journal, the New York Times, and the Washington Post — never mentioned the word money. M-o-n-e-y. And it’s the creation or destruction of money that is the Fed’s primary job.

It was too much money chasing too few goods that caused the inflation of the 1970s, and too little money in relation to the availability of goods that has caused the deflation of the last few years.

Newspaper writers, listening carefully as Fed staffers whisper in their sensitive ears, are blaming deflation on subpar economic growth, and they say the lagging economy has created a growing “output gap” between potential and actual economic activity. But we learned painfully in the 1970s that inflation can coexist with recession. Milton Friedman coined the term “inflationary recession,” which then became known in the media as stagflation.

Then came Reagan advisors Arthur Laffer and Robert Mundell. They argued for monetary restraint as a cure for inflation, and significantly lower tax rates to produce an economic recovery. This supply-side mix is just as important today. The cure for deflation is monetary expansion. And, yes, the recipe for economic growth centers on more tax-rate reduction.

This week’s action from the Fed seems to suggest that they will not be raising their target interest rate for a long time. This should mean that open market operations will be opening up the money spigots a lot wider. If so, this would be very good news. However, so far the Fed hasn’t delivered. President Bush has sponsored a huge tax cut, exactly the right medicine for this economy. Now it’s up to the Fed to support it. It must keep showing us the money.

Mr. Kudlow is CEO of Kudlow & Co.