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A Temporary Power Outage in an Otherwise Bright Economy

By Lawrence Kudlow

Wall Street remains caught in a tizzy over a power outage in the credit markets. But Main Street is in fine economic shape, according to the latest reports out of Washington.

Industrial production -- one of the most important coincident indicators out there -- is steadily rebounding. Overall, it's up 2.9 percent annually over the past three months. Manufacturing is up 4.7 percent. Auto output has increased 19.4 percent. Computers and office equipment are up a whopping 25 percent.

These are big numbers. And Americans are buying what these businesses are producing. Overall retail sales are up 4.8 percent for the past three months at an annual rate.

Sure, housing is still soft. But building-material sales are up 11.4 percent for the past three months. General merchandise and department stores are up roughly 10 percent. Clothing stores are up 12 percent.

Meanwhile, the latest inflation numbers from the consumer price index are tame. Headline inflation is up 2.4 percent over year ago, and core inflation is at 2.2 percent. On a more accurate chain-weighted basis, the overall CPI rose only 2.1 percent with a core increase of 1.8 percent. Gasoline prices have dropped about 50 cents at the pump.

Wall Street is beating up Wal-Mart for expected growth of only 2 percent. But the Democrats' most-hated American company actually posted a 49 percent gain in profits over the past year. As Jimmy Pethokoukis of U.S. News reports, Wal-Mart's $11 billion in profits came with sales of $345 billion -- an 8.8 percent gain over a year ago and nearly twice the growth of U.S. nominal GDP. Over at Costco, profits have gained 14 percent. Target is up 20 percent. Low-end retailers (at least these boys) are doing pretty darn well.

Economists David Malpass and John Ryding at Bear Stearns believe second-quarter GDP will be revised up from 3.4 percent to over 4 percent, while third-quarter GDP will come in at a minimum of 2.5 to 3 percent. So, despite the fact that stocks have hit an air pocket and credit markets are suffering a temporary power outage (to borrow a term from economist John Rutledge) the country is not plunging into recession.

That said, the financial liquidity squeeze triggered by the sub-prime virus is a very difficult near-term problem.

Everyone's watching the Fed, and markets are strongly signaling a Fed ease. Supply-sider Paul Hoffmeister, chief economist at Bretton Woods Research and a former staffer to the late Jude Wanniski, believes a Fed ease would help spur economic growth. What's more he thinks the added liquidity will bring more bidders to the mortgage credit market, while added growth at the margin will mop up some of the inflationary pressures visible in $670 gold.

Smart guys on Wall Street are telling me the central bank ought to expand its collateral regulations so that open-market purchases can channel new cash into non-government-backed mortgage pools, jumbo mortgage loans, and asset-based commercial paper. This would channel the flow of new credit to specific areas that need help. Unfortunately, even money-good paper is being tarnished by the relatively low percentage of money-bad sub-prime paper.

Credit markets really need a short-term liquidity rescue operation. This would allow well-managed lending institutions to survive the credit squeeze without going under. There's about $2.2 trillion dollars of asset-backed commercial paper that has to be rolled over as financial institutions de-leverage their positions. If the Fed started buying, healthy banks would follow suit and relieve the trading freeze.

Meanwhile, the Treasury Department might let Fannie Mae and Freddie Mac expand their mortgage loan purchases and balance sheets under certain conditions to be clearly spelled out in congressional legislation. Rep. Barney Frank's House Financial Services Committee has a decent bill to raise GSE loan limits. But the Senate must take it up soon if it's to have an impact. Conceivably, Fannie and Fred could even buy sub-prime mortgages. At the margin this would help.

Speaking on deep background, one Treasury official told me that while the department is constantly in touch with federal bank regulators, private sector banks, and mortgage lenders, 80 percent of the liquidity-enhancing tools are at the Fed.

What we've got here is a profitable business sector that is generating ample incomes, jobs, and consumer spending despite the low-income housing-loan problem. Remember, less than 1 percent of total mortgages are in sub-prime foreclosure. And the global economic boom, as represented by surging U.S. exports, provides yet another cushion to the overall economic story.

While the credit power outage is a big problem, the Fed and Congress could provide the key solutions. But the economy is not dead. Not by a long shot.

Lawrence Kudlow is a former Reagan economic advisor, a syndicated columnist, and the host of CNBC's Kudlow & Company. Visit his blog, Kudlow's Money Politics.

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