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Do No Harm
The Fed must recognize our current low-inflation, post-Katrina realities.


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Larry Kudlow

By Lawrence Kudlow & William P. Kucewicz

With gold knocking at the door of $470 an ounce, a degree of uncertainty has crept into the inflation outlook, making today’s likely quarter-point boost of the federal funds interest rate more palatable. An interest-rate hike, however, shouldn’t be the most important news to come out of the Federal Reserve’s latest policymaking powwow. Unique circumstances call for a change in how the Fed directs its domestic policy. It must signal that it will adhere to the age-old Hippocratic oath to “do no harm.”

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Of most immediate concern to our central bankers are the economic and fiscal effects of Hurricane Katrina. The U.S. economy has essentially lost a city overnight, and this loss will continue to take a toll for some time. Katrina’s effects will probably slow the expansion of gross domestic product by a percentage point or more in the third quarter, resulting in a real growth rate around 2 percent. Economic activity should pick up in the fourth quarter, though, as post-storm repair and rebuilding efforts contribute positively to both output and employment.

But the key here remains to “do no harm.”

Excess money in the economy is the root cause of inflation, and to date the Fed has done a good job of containing it. According to the inflation model utilized by economist Arthur Laffer (which in simple terms subtracts money demanded from money supplied), the rate of excess money creation averaged 2.4 percent in both the three-month and six-month periods ended in August. Over the last twelve months, the rate of surplus money creation was just 1.5 percent.

This explains why core inflation remains low. The “chained” consumer price index (a.k.a the Boskin index, which is weighted annually), less food and energy, was up just 1.8 percent last month from August 2004. The standard consumer price index, again less food and energy, was up 2.1 percent. These basic inflation readings have been steady for ten months.

But gold remains a core indicator of future inflation, and the recent spike near $470 an ounce demands attention. Prior to this, gold had traded in a generally narrow range in the past nine months, with a high last Friday of $457.20 and a low of $411.10. The London afternoon fixing price had ranged from 6.3 percent above the nine-month average ($430.06) to 4.4 percent below it. That’s a fairly stable record.

Other real-time indicators also have reflected a non-inflationary monetary environment. Bond yields around 4.25 percent remain at four-decade lows. Spot commodity prices (that exclude energy and gold) have flattened out and stabilized over the past twenty months. The exchange value of the dollar has been gradually rising this year. Even the oil spike is abating. Sweet West Texas intermediate crude is trading around $65 a barrel, 7 percent off its August 30 peak. Unleaded gasoline has plummeted 25 percent.

The Fed, nonetheless, has a close call. It may decide that the temporary loss of economic output from the Gulf Coast could set up an inflationary threat from too much liquidity chasing a short-term loss of goods. This could explain the recent gold price increase, and it might induce the central bank to withdraw excess liquidity by raising the key interest rate to 3.75 percent from the prevailing 3.5 percent.

Fortunately, President Bush has signaled his aversion to any tax increases to finance emergency Katrina assistance. So the tax-cut extensions for capital gains and investor dividends appear likely to pass in next month’s budget act. This pro-growth policy will be bolstered by Bush’s use of Jack Kemp’s enterprise-zone tax-and-regulation-free policies to rebuild New Orleans and the Gulf area. These measures will quickly restore private capital formation and lost output and help bring monetary policy back into non-inflationary balance as the availability of more goods will absorb excess liquidity.

What’s needed from today’s Fed meeting, therefore, is a recognition of our current low-inflation, post-Katrina realities. Let policymakers raise the fed funds rate to 3.75 percent if they will. But also let them recognize that this economy doesn’t need any more braking. Let them issue a policy directive indicating that monetary tightening has ended for now, putting the key interest rate in neutral. Let them take credit for restraining inflation by keeping money creation generally in check.

But most important of all, let them recite the central bankers’ Hippocratic oath to “do no harm.”

— Larry Kudlow, NRO’s Economics Editor, is host of CNBC’s Kudlow & Company and author of the daily web blog, Kudlow’s Money Politic$. William P. Kucewicz is editor of GeoInvestor.com and a former editorial board member of the Wall Street Journal.



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