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Inflation Tames
So should the Fed.


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Larry Kudlow

Hawkish inflationism on Wall Street took a bath with the release of an anemic producer price report late this week. The producer price index (PPI) — a measure of what businesses are paying for goods and materials — shows that inflation is in fact falling.

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Prices of finished goods have declined in two of the past three months, amounting to a 1.1 percent decline-rate over the period. More, the core PPI registered a marginal 0.5 percent at an annual rate over the past three months, including a one-tenth of a percent price drop in August. After an early-year inflation flare-up, price indexes are settling in around zero.

Noteworthy is the 2.1 percent annualized decline-rate in the price of consumer goods over the past three months, and a 13.6 percent deflation-rate for computers. Overall, capital-goods prices are rising less than 1 percent, while the price index for durable goods (in the July report for consumer spending and income) plunged 1.9 percent over the past twelve months.

These wholesale price results corroborate the softness in non-energy commodity indexes — including metals, where aluminum-producer Alcoa just issued a profit warning. (Alcoa stock promptly dropped 7 percent.)

The commodity-price rebound of 2003 was a normal, post-tax-cut, first-recovery-year bounce, especially as it came off the deflationary trend of 2000 to 2002. But now price trends on the wholesale side are settling into a very docile range. This should be of no concern to policymakers at the Federal Reserve. Price stability on the producer front is the new watchword. There’s simply no inflation warning in any of this.

Here’s some more evidence: The value of the dollar has stabilized relative to commodities (including gold) and foreign currencies. The inflation-forecasting government bond spread (the 10-year Treasury market rate minus the 10-year Treasury inflation-adjusted rate) has recently fallen below its 200-day and 50-day moving averages. This confirms that expected inflation is coming down along with actual inflation.

Money supply trends, a potential inflation signal, are also well balanced. Over the past year the monetary base supplied by the Fed is running around 4.5 percent. That’s about the same pace as the average growth of traditional money-demand indicators such as M1, M2, and M3.

The market, meanwhile, is foreshadowing a 25 basis-point increase in the Fed’s base policy rate at the September 21 open-market meeting. The 3-month Treasury bill rate is running around 1.65 percent, just ahead of the 1.50 percent fed funds interest rate.

Certainly, this won’t be the Fed’s last move in this recovery cycle. With the 2-year Treasury now around 2.46 percent, the 3-month T-bill rate could be near 2.5 percent by August 2006. But this would be a tame and cyclical interest-rate rise; one that is much more benign than the current consensus of economic forecasters would have us believe.

A tame Fed would match up perfectly with this turn in the inflation tide. In view of the apparent shift back to core price stability this spring and summer, the central bank has plenty of room for a multi-month pause after it raises rates later this month.

With productivity trending around 3 percent over the past ten years and average labor-force growth running around 1.2 percent annually, the U.S. economy’s potential to grow is now about 4.25 percent yearly. Unemployment will decline if this growth rate is maintained. Surely the Fed would not wish to interfere with this outcome by pursuing fictitious inflation with interest-rate overkill.

A 4.25 percent real economic growth rate is about 1.5 percentage points faster than long-run Congressional Budget Office estimates. What those green eyeshades at the CBO fail to understand is that higher productivity rates bolstered by lower tax rates on capital formation will grow the economic pie larger and create a flood of new tax revenues at lower tax rates. As surplus revenues fill-in the budget gap, budget surpluses, rather than gloomy deficit projections, could reappear by 2011.

Of course, all of this is provided the Fed keeps its paws clean and Congress holds tax rates down.

— Larry Kudlow, NRO’s Economics Editor, is CEO of Kudlow & Co. and host with Jim Cramer of CNBC’s Kudlow & Cramer.



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