December 17, 2005
A Friend at the Fed?
By Lawrence
Kudlow
Unlike a lot
of economists, I've never truly believed that the Federal Reserve
is really my friend, or a friend of financial markets and the
economy.
True enough,
I started at the New York Fed over 30 years ago and got a good
education there. But frankly, I'd rather bet on America's free
economy -- and the men and women who do the real heavy economic
lifting by exercising their God-given talents to invent, produce,
take risks and work hard at their jobs -- than bank on the Fed.
This is
provided, of course, that the U.S. government gets out of the
way by allowing for sufficient after-tax rewards and incentives.
Deregulate America, and U.S. capitalism will soar. Whether it's
monetary or fiscal, central planning is the antithesis of prosperity.
All of that
said, a quick thought passed through my mind following the Fed
policy meeting last week. I had just closed my eyes and leaned
back while listening to some calm music, and I almost came to
believe that the high priests of money might be basing their policy
on forward-looking bond indicators, which is exactly what they
should be doing. The question is: Will friendly thoughts like
this last for very long?
I still
can't forgive the central bank for decimating and deflating the
bullish stock market economy five years ago, a move that temporarily
ended the great productivity surge of the Internet revolution.
But perhaps they have learned a thing or two, and perhaps the
arrival of the brilliant Ben Bernanke as Fed chair will be an
occasion for real change.
In shorthand,
the Fed's policy statement last week strongly suggested that the
recent 18-month tightening cycle soon will come to an end. It
raised its target rate from 4 percent to 4.25 percent, and perhaps
there's another small move or two left. But bond-market indicators
have for quite some time been signaling an absence of inflationary
pressures -- a matter confirmed by the actual data, where the
basic inflation rate continues under 2 percent.
Not only
has the 10-year Treasury bond been hovering at a half-century
low of 4.5 percent for many years, but the difference between
this cash bond and its inflation-indexed cousin suggests that
low inflation is here to stay for another decade.
Moreover,
broad-based inflation reminds me of Jimmy Carter. And despite
the best efforts of the mainstream media, George W. Bush is no
Jimmy Carter. Nor are these the inflationary Carter '70s. Lower
tax rates and skyrocketing productivity are counter to
inflation.
Now, some
of my supply-side friends take issue with my optimistic view on
inflation. They believe the recent run-up in gold prices to over
$500 an ounce signals excess money creation and much more inflation
ahead. Therefore, some argue, the central bank must keep tightening
and raising its target rate for at least another year.
But I believe
this is a 1970s view -- one that abstracts from the Internet Google
revolution and the record productivity surge, and also ignores
the global spread of capitalism, which has taken hold in the post-Reagan
years and has increased the demand for scarce commodities across
the board.
Consider
this: Daily average volume in the Treasury bond market runs up
to nearly $90 billion, according to the Chicago Board
of Trade. Gold trading, however, is well below $50 million,
even in the recent rally.
In other
words, the vast breadth, depth and resiliency of the bond market
suggest that this forward-looking indicator has the most clout
in the world marketplace. This does not mean that gold is irrelevant
as a monetary signal -- but it does suggest that the Fed is on
the right track with what appears to be a newly created bond-price-rule
approach to policy. In other words, the central bank seems to
be using the bond market as its leading real-world indicator.
In my view,
this is as it should be. And if the authorities are still worried
about a touch of future inflation, all they need do is sell bonds
from their huge portfolio in order to drain liquidity and bypass
the unnecessary fed funds rate target altogether.
As for gold,
it may still be taking the temperature of global war and political
uncertainty, and today it could be telling us more about the threat
of nuclear weapons in Iran than the future course of American
inflation.
For years,
conservative economists have argued for a well-defined price rule.
As the Fed moves into the Bernanke era, it looks like we're getting
one. Between forward-looking bond markets and backward-looking
basic inflation rates, the central bank should be able to find
the right policy that will not interfere with the day-to-day inspirations
of the American entrepreneurs who have made our form of prosperous
capitalism the envy of the world.
Lawrence
Kudlow is a former Reagan economic advisor, a syndicated columnist,
and the co-host of CNBC's Kudlow
& Company. Visit
his blog, Kudlow's Money
Politics.
