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Three More Years of Goldilocks?

By Lawrence Kudlow

There was some revealing information in the three-year forecast published by the Federal Reserve this week. It looks like Ben Bernanke & Co. are dissing high oil and gold prices and the sagging dollar as influences on future inflation. Instead they basically see 2 percent inflation -- both headline and core -- in 2008, 2009, and 2010. The Fed also sees Goldilocks-type economic growth -- not too hot, not too cold -- for the next three years.

For 2008, an election year, the Fed is looking at 2.1 percent growth, their lowest estimate. This rises to 2.5 percent in 2009 and 2010. A slower 2008 does make some sense given the lingering sub-prime hangover and the housing recession. But one wonders if the Fed might be thinking about higher tax rates under a Democrat like Hillary Clinton, which would produce sub-standard growth for the longer term.

Nevertheless, with the Fed forecasting 2.1 percent growth next year, it certainly looks like they'll follow Treasury bond market interest rates down toward a 3.5 percent federal funds rate. (Of course, today's rate stands at 4.5 percent.) On CNBC this week, former Fed governor Wayne Angell told me to expect this, and former Dallas Fed president Bob McTeer agrees. My own view remains the same: The Fed will skip a rate cut at their December 11 meeting in order to help stabilize the greenback in the foreign exchange markets. But they eventually will move their target rate down several times this winter.

That said, I think the election-year economy will be stronger than the Fed's estimate -- closer to 3 percent. Too much is being made of both the sub-prime credit problem and the housing downturn. A recent Bank of England study shows that residential mortgage-backed securities in the U.S. total $5.8 trillion. Of that, only $700 billion, or 12 percent, are sub-prime. Even when you add in $600 billion of so-called Alt-A mortgage paper, most of which will not default, the total of these home loans is still less than 20 percent of all mortgage-backed paper.

What's more, the entire market in sub-prime debt is just 1.4 percent of the global equity markets. On any given day, a 1.4 percent drop in world stocks would erase the same amount of value as the collective markdown of all sub-prime-backed bonds to $0. It's just not that big a deal.

And with all these problems, economic growth in 2007 will probably come in around 2.8 percent, a pretty good year. Plus, the Fed has already eased 75 basis points, which will stimulate next year's economy. On top of all that, after-tax, after-inflation income is booming at a 4 percent rate over the past twelve months. Exports are strong, off-setting the housing slump. Both consumer spending and business capital investment are advancing. Tax rates will remain low. So all this talk of recession seems greatly exaggerated.

One key indicator in a presidential-year economic forecast is the stock market. Right now, stocks are in a classic declining-profits correction. This downward trend has so far reduced the Dow by roughly 8 percent. As a rough guess, a 10 percent correction ought to spell the end to the Dow's slump. And Fed rate cuts should be a big booster for stocks. However, if the Dow correction extends to a 20 percent drop, it could spell recessionary disaster for Republicans next November.

As far as next year's election is concerned, the investor class leans heavily Republican. They are a smart, savvy bunch, and they know darn well that Hillary Clinton won't hesitate to raise taxes across the board. But if a recessionary bear-market rears its head, many investors may indeed revolt by voting Democratic.

We've seen this movie before, most recently in reverse. The year-2000 bear-market recession helped catapult George W. Bush in the polls while stymieing Al Gore. In the 1992 contest, although the stock market and economy were slowly coming back to life, the elder Bush suffered at the hands of Bill Clinton and Ross Perot mainly because of the recessionary bear-market credit crunch of the early 1990s.

So here's my message to all the GOP candidates on the presidential campaign trail: You better have your specific pro-growth tax policies in order. Hillary Clinton and Barack Obama will certainly be raising taxes, and the GOP must cut them. So far, former Tennessee senator Fred Thompson is preparing to unveil a corporate tax cut for business income and capital gains. That's what I call the right medicine for a sluggish economy. GOP candidates also should keep a close eye on the stock market. I still believe it's the best political and economic barometer out there.

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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