If you prefer a commodity-price-rule approach to monetary policy, the following will beg your attention.
The Commodity Research Bureau’s spot commodity index (which excludes oil and gold) has been flat for about 19 months, stretching all the way back to early 2004. This commodity flattening follows the sharp commodity recovery of 2002-03, which itself followed a protracted period of commodity deflation that reached back to the 1997-2001 period.
So it’s been a bumpy ride for Federal Reserve policy. But the key point, insofar as Fed strategy should be concerned, is simply that the central bank has succeeded in removing most, if not all, of the excess liquidity they created following 9/11 and the vicious deflation that preceded the terrorist attacks.
In my view, the Fed should declare victory and stop their auto-pilot restraining actions before they completely flatten or invert the yield curve. It is also worth noting that despite the recent run-up in oil prices to the $60 zone, the breakeven TIP spread shows no inflation impact from oil.
The recent rise in bond rates stems mostly from rising real rates (as indicated by the inflation-adjusted TIPS yield) in response to rising business investment expectations. Hence, inflation remains contained at slightly less than 2 percent, excluding the globally driven demand shock for oil.
Futures markets paint a gloomier picture. These markets are forecasting a near 4.25 percent fed funds rate by next winter and a 4.5 percent 10-year bond yield. Should this severe curve flattening take place, it would pose a significant threat to economic growth.
Read James Hamilton’s piece, “When Should We Worry About the Yield Curve?“. Hamilton, an economics professor at UC San Diego, writes that “one of the best-established predictive relations in macroeconomics is the observation that, when the difference in yields between long and short-term interest rates is low or negative, future GDP growth tends to be slow or negative.” He points to academic research that shows a number of bond market relationships that bear this out.
Traditionally, economic models use the differential between 10-year bond rates and three-month bill rates, but some research shows that even the difference between a 3-year bond and a 2-year bond is just as accurate as an economic forecaster. Over the past 50 years the traditional spread has averaged 140 basis points. Today, as the Fed moves its target rate to 3.5 percent from 3.25 percent, the Treasury spread will be less than 100 basis points.
Though Maestro Greenspan has belittled the Treasury interest-rate spread model, Professor Hamilton points to studies by John Galbraith and Greg Tkacz published in the Journal of International Money and Finance in 2000. There is also a study of yield curves and their forecasting power over future industrial production by Ivan Paya, Ioannis Venetis, and David Peel, published in the Journal of Forecasting in 2004. All these academic works confirm the proposition that the smaller the gap between long- and short-term rates, the more pessimistic the forecast of future economic growth.
In recent years Alan Greenspan has resorted to carefully selected economic anecdotes to prove or disprove various policy issues — mostly to suit his own instincts. But it was Greenspan’s departure from the commodity price rule and the inverted yield curve in 2000 that generated an unprecedented liquidity deflation which was followed soon by the worst stock market in over 60 years and the ensuing crash of business investment.
Today it would appear that the Maestro is once again choosing to overlook the clear message of commodity prices and the Treasury yield curve. That market message is telling the central bank that they have removed enough monetary accommodation to maintain domestic price stability. So why not declare victory and get out?
Spurred by lower tax-rates on capital and high output-per-worker productivity, along with a global anchor for prices and wages that stems from the intense competition brought on by India, China, and other emerging economies, the U.S. is enjoying non-inflationary prosperity with significant new job creation and low unemployment.
The supply-side tax cuts of 2003 have triggered a new boom in business capital goods investment that is modernizing technologies and expanding our infrastructure’s capacity to grow. This, itself, is counter-inflationary. Since early 2003 the contribution to GDP growth from business investment has moved up to nearly 30 percent from zero. At the same time, the consumer-spending contribution has moderated to a sustainable 70 percent from 90 percent.
Capital formation is highly responsive to lower tax-rate incentives, and once again this supply-side theory is being proven in the real world. The re-emergence of prosperity is a wonderful thing. Even the mistakenly maligned housing boom is helping rebuild inner cities such as Harlem, New York, and Baltimore, Maryland. Mortgage credit is available to even the lowest income groups, which are creating new wealth through the purchase of new homes. This process, in turn, is providing the monetary resources for an unprecedented build-up in small-business creation, especially minority-owned businesses.
The trick for Maestro Greenspan is to effectively manage the nation’s money supply so that the march toward full employment will not be interrupted. There are no better policy guideposts for this task than commodity price indexes or the venerable Treasury yield curve.
These tools were successfully pioneered from the mid-1980s to the mid-1990s by market-price advocates Wayne Angell and Manley Johnson when they sat on the Federal Reserve Board. These Reagan appointees helped conquer inflation.
If the soon-to-be-retiring Greenspan takes his eye off the ball, he could well prevent the American economy from realizing its fullest potential.
— Larry Kudlow, NRO’s Economics Editor, is host of CNBC’s Kudlow & Company and author of the daily web blog, Kudlow’s Money Politic$.