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Inflation Worriers, Dollar Pessimists
For too many on Wall Street the glass is always half empty.


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Larry Kudlow

As the whole world expected, the Federal Reserve continued its policy of normalizing short-term rates by raising its policy target to 2 percent this week. Since last June the fed funds rate has doubled, but long-term rates have defied conventional wisdom by actually falling. This is a great sign that neither actual nor expected inflation is a problem.

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So far in the Bush recovery cycle the inflation worriers have been wrong. In fact, lower marginal tax rates put into action by the president have contributed to minimal inflation and sustainable economic growth.

It’s interesting that even many supply-siders have forgotten the counter-inflationary impact of lower taxes. Stronger employment and higher investment are responses to lower tax rates. Therefore, increased production and economic growth are absorbing excess money and holding down inflation. Over the past year the consumer spending deflator has increased only 2 percent, while the core inflation measure (excluding energy) is a miniscule 1.5 percent.

The Fed is doing its part to maintain domestic price stability by gradually raising its interest-rate target and slowing the pace of new-money creation. It is also paying attention to real-time market-price signals as a guide to policy making.

Recently the 3-month Treasury bill leapfrogged the federal funds target rate and the gold price moved up to $435 an ounce. These were market signals that the Fed’s interest rate was too low and that the central bank should withdraw some money in order to prevent rising inflation.

That Greenspan & Co. is moving gradually but steadily to remove the emergency money-supply stimulus created after the 9/11 attack is a positive omen that brightens the outlook for long-run, non-inflationary economic growth.

Numerous pessimists littering Wall Street have also taken to gnashing their teeth over a softening dollar. For them the glass is always half empty. Conservative economists want the Fed and the Treasury to rescue the dollar. But this can only be done with a much more radical monetary tightening by the Fed, perhaps combined with a futile Treasury currency-market intervention policy. All this would be a mistake. It might even sink the economy.

First of all, the dollar is fundamentally undervalued right now. With the U.S. economic-recovery miracle continuing to build, and with the successful battle of Fallujah moving us closer to democratic elections in Iraq, the dollar is actually poised for a major rally. But perhaps only optimists can see this.

For now, the real problem with the dollar is not so much that the Fed is too loose, but much more that the euro is way too tight. Just as with foreign policy, Old Europe has the monetary story wrong. The creation of new euros is way too stingy; it is in fact still deflationary.

Consequently, Eurozone economic growth has averaged a recessionary 1 percent in recent years, whereas the U.S. recovery rate has been 3.5 percent. America lowered tax rates, but the Europeans refused to do so. Top-heavy social spending and excessive regulating of business and labor markets also suppress Eurozone growth. In comparison with the U.S., not only does Europe not work, not produce, and not invest — with terrible productivity to boot — their monetary policy is scorched-earth deflationary. Old Europe has dug itself into a deflationary hole.

However, a number of Fed officials have made matters worse by talking the dollar down. This is dumb. They believe the large U.S. current-account deficit requires a cheaper dollar. This is also dumb. Trade deficits no more sink exchange rates than budget deficits drive up interest rates. Both currency values and interest-rate levels are determined by monetary policy — not the so-called twin deficits.

Because the U.S. economy is growing much faster than its biggest export customers, we are buying more from them than they purchase from us. Rapid growth in China and India over the next decade will correct our trade imbalance. In the meantime America’s low-tax, high-profit economy is attracting private-capital inflows from all around the world. Lately, foreign inflows have come in around $600 billion, about the same as our $570 billion current-account deficit. There is no financing problem.

That said, it would be foolish if the U.S. Fed started targeting a fixed dollar-euro cross-rate. If the Europeans are stupid enough to crash their economy with overly tight money, that’s their business. But the U.S. must not make the same tight-money mistake and wreck this prosperous recovery.

Instead, domestic price stability should be the Fed’s strategic goal. As long as the U.S. central bank ties its policy to a domestic price rule — guided by financial- and commodity-market indicators — as Greenspan seems to be doing, then the U.S. will continue along a path of non-inflationary prosperity.

Fortunately, in his final cycle as Fed chairman, the maestro remains at the top of his game.

— 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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