Politics & Policy

Low Inflation Is in The Money

The Fed should take a breather.

Katrina or not, monetary trends are pointing to a mild slowdown in the U.S. economic growth rate. But the risk of inflation is still well contained.

Remember, the root cause of inflation is excess money — not too many people working; not too much prosperity. This makes money the most powerful of all the economic policy variables. Add to that tax rates, federal regulations, and trade policy, and you have a framework for prosperity creation or destruction.

Back to money, I use a 36-month “smoothing technique” to clarify the major money-supply trends. I also use the same model for calculating the velocity, or turnover rate, of money. The results show some very clear trends. First, on the demand side, the slower growth of money measures like MZM and M2 is partially offset by a faster hand-to-hand turnover of money since the middle of 2003. This implies a growth rate of roughly 5.5 percent for nominal GDP (or GDP measured in current dollars).

Over the past couple of years nominal GDP has grown at around 6.5 percent annually. So it’s possible that future GDP growth will slow by about a percentage point.

As for the supply of money, which is controlled and created by the Federal Reserve, a clear slowdown has taken place since the mid-2004 restraining policies were first initiated. That, coupled with rising investment demands in part fueled by lower tax rates on capital, has worked to remove the excess money printed by the central bank in 2002 and 2003.

As I have often noted, the Treasury yield curve has flattened, bond rates are historically low at just above 4 percent, spot commodity prices (excluding oil and gold) have been flat for almost 20 months, the gold price has been trading in a narrow range, and the dollar has stabilized. All of these real-time inflation-sensitive market-price indicators are reflecting a rollback of inflation risk. Draining of liquidity by the Fed has also contained the impact of the energy spike so that core inflation remains around 2 percent or slightly less.

I wish the Fed would add or drain reserves with a sharp eye on financial and commodity prices instead of the overnight federal funds rate. But the fact remains that the monetary authority has thus far done a pretty good job of maintaining monetary balance and domestic price stability. In other words, this would be a good time for Alan Greenspan & Co. to take a breather and assess the results of their policy restraint. The Fed should take the next six months off.

In a nutshell, here’s the inflation situation: Supply-side tax cuts over the last two years have increased the demand for money (and economic growth). Meanwhile, Fed restraining actions have reduced the growth of money supplied. Therefore, inflation risk has been minimized. Will the Fed avoid the mistakes of the past and not over-tighten? Will lower tax-rates remain in place? If the answer to each question is yes, the outlook remains bright.

Contrary to what many Democrats are saying, the likelihood of a tax hike to finance temporary Katrina spending is virtually nil. In recent interviews, White House economic advisor Al Hubbard made it clear that the president is a tax-cutter, not a tax-raiser. Sen. Kay Bailey Hutchinson (R., Tex.) emphatically stated that Congress will not raise taxes. Meanhwhile, Sen. Jeff Sessions (R., Ala.) suggests the appointment of a leading business person to oversee Katrina relief and cleanup. This is an excellent idea and the White House is looking at it. The Bush administration is also entertaining the idea of appointing a retired military general like Tommy Franks to head the cleanup effort. Former Sen. Jack Kemp’s idea of rebuilding the hurricane-ravaged private sector through tax-free enterprise zones and vouchers for housing and education should be a key part of Katrina policy.

As for whether or not Federal Reserve monetary policy will play along, we’ll have to wait and see. Perhaps when Greenspan steps down next year his successor won’t have us guessing so much. May I make two suggestions for the next Fed chair? University of Pennsylvania professor Jeremy Siegel and former Fed vice chair Manley Johnson would make excellent candidates. Johnson wrote the book on the commodity price rule while Siegel carefully monitors financial and commodity indicators of inflation. Both have solid academic and financial-market experience.

A Fed that lets real-time financial and commodity prices guide monetary policy? Imagine that.

— Larry Kudlow, NRO’s Economics Editor, is host of CNBC’s Kudlow & Company and author of the daily web blog, Kudlow’s Money Politic$.


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