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The Fed has done well (so far) in 2004.


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Larry Kudlow

You have to give the Federal Reserve some credit.

The central bank typically goes off-line by targeting things they shouldn’t instead of the things they should. Rather than basing their monetary decisions on real-time market-price indicators — like the value of the dollar and Treasury-market interest rates — Greenspan & Co. too often target real economic variables such as jobs, unemployment, or non-existent Phillips-curve tradeoffs between economic growth and inflation.

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This approach has frequently knocked down economic growth, as was the case in 2000 when massive monetary mistakes totally deflated the technology boom and the stock market.

Yet, while Fed rhetoric on policy targets hasn’t improved that much, the actual results of this year’s rate-hiking have so far been good. For example, while short rates have gone up, long rates have actually come down. This suggests that some small Fed rate-hikes at the short-end of the curve have actually reduced bond yields on the long-end.

The occurrence of rising short rates and falling long rates is known as the “monetary paradox.” In theory, this suggests that the Fed’s removal of excess money with an increase in the base target rate from 1 percent to 1.5 percent has reduced inflation fears according to falling bond rates. Since expected domestic price stability should be the Fed’s number-one goal, it would appear that Greenspan & Co. is getting the job done.

Bond yields move inversely to prices. One of the biggest surprises this year is that Wall Street bond bears have been completely wrong. Instead of spiking up, Treasury bond rates have actually fallen from nearly 5 percent to almost 4 percent. This has also bolstered housing, with a surprise drop in mortgage rates.

Meanwhile, the broad S&P 500 stock index has increased slightly this year by almost 1 percent after rising 26 percent last year. And though buffeted by rising energy prices, gross domestic product (excluding miscalculated trade deficits) has still grown at a 4.5 percent annual rate. While consumer spending has been pinched by a big jump in gas prices at the pump, business investment has more than taken up the slack.

Many observers argued that the central bank would not dare raise its target rate during an election year. But the idea that political pressures can unduly influence the independent central bank has again been proven wrong. The Fed was overly stimulative in 2003 and they are removing the excess money in 2004 — election or not.

More evidence of Fed success can be seen in the rising value of the dollar. Relative to foreign currencies, gold, and broad commodity indexes, dollar value has appreciated by roughly 5 percent. On balance, over the course of this year, the Fed’s supply of bank reserves and currency in circulation has declined somewhat — from nearly 6 percent annual growth to just more than 5 percent as measured by the adjusted monetary base.

Inflation readings have slowed markedly in recent months from a brief bump-up last winter. Presently, the core consumer price index is 1.7 percent higher than a year ago, with the chained index of the core CPI only 1.2 percent ahead of August 2003. With a historically low 5.4 percent unemployment rate, it is clear that low inflation, relatively high economic growth, and low unemployment can peacefully coexist.

It is also clear that supply-side tax cuts that lowered marginal rates on work effort and investment (investor dividends and capital gains) have helped spur economic growth. At the same, the tax cuts have held down inflation through the production of more goods and services to chase the existing money supply. In other words, more money is countered by even more growth.

Keynesian economists should take their Phillips-curve models — that incorrectly trade off growth and prices — and bury them once and for all in the dustbin of history. While they’re at it, these apostles of government planning should also finally acknowledge that while short-term interest rates are heavily influenced by the Fed, long-term rates are completely at the mercy of market forces and their expectations of future inflation. Temporary budget deficits don’t drive up long rates, but inflationary money does.

Surely the Fed will raise its base target rate today by one-quarter of a percent to 1.75 percent. With oil prices around $46 and gold slightly above $400, this seems to be the right move.

There is no open-market meeting in October, so the central bank and the financial markets get a breather. Whether the Fed will resume its gradual rate-hiking later in the year is unclear.

But so far they have done well. The classic monetary paradox of rising short rates and falling long rates is a positive development. Bucking the consensus tide, my best guess is that the maestro could take a few months off from new restraining moves. Let’s see what market-price signals are telling us.

— 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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