Federal Reserve policy is no longer accommodative, according to the central-bank high priests of money. They removed the “accommodation” sentence from Tuesday’s announcement that the key interest rate will be lifted another quarter point to 4.25 percent. This is a very important signal that the tightening cycle is nearing an end.
Bond spreads confirm the Fed view. First, the inflation-indexed 10-year Treasury is 2.15 percent, which is the natural, or neutral, real interest rate in the economy. Second, if you subtract this rate from the cash bond of 4.53 percent, you get 2.38 percent — which is the market’s forward-looking inflation expectation. Third, subtract that 2.38 percent forward inflation rate from the 4.25 percent nominal fed funds rate and you get a 1.87 percent real fed funds rate. This is roughly 25 basis points below the 2.15 percent natural rate of the economy.
The Fed’s statement on Tuesday held that “further measured policy firming is likely to be needed.” But the Fed is very close to neutral — actually one more 25-basis-point tightening move will do it.
Whether the Fed moves one more time (to 4.5 percent) or two more times (to 4.75 percent) is of little consequence to the stock or bond markets. The key point is that the light at the end of the tunnel can now be more clearly seen. Stocks are rallying nicely, including financials (like banks and brokers). February gold dropped $7.60, the greenback firmed, and the 10-year note rallied slightly. In other words, markets liked both the Fed move and the Fed message.
Ben Bernanke will take over as Fed chair in a month and a half and the FOMC will leave him some flexibility by keeping the “measured” language intact. But Bernanke watches bond-market spreads, including the yield curve differential between 10-year’s and funds, which is now only 30 basis points, as well as the forward-looking TIPS spread inflation outlook.
Meanwhile, the Fed noted that the economy is in a period of solid growth with low core inflation. I agree. Given the profitability of American companies, as well as the Google Internet productivity revolution, this bodes well for the stock market.
Gold prices are still too high based on my reading of virtually no domestic excess money. But rather than inflation, the gold price may be driven by international tensions related to Iran’s nuclear buildup and an Israeli threat to take military action. You can also add in the sad state of economic policy in Germany, which threatens the viability of the euro. These factors are reducing international currency demands, hence the gold price has been bid up.
At home, a successful extension of investor tax cuts, not likely until January, would also raise U.S. money demand and reduce gold prices. This could be an important nail in the gold coffin.
— Larry Kudlow, NRO’s Economics Editor, is host of CNBC’s Kudlow & Company and author of the daily web blog, Kudlow’s Money Politic$.