- The Washington Times - Tuesday, April 11, 2000

Headline news stories following Alan Greenspan's White House speech last Wednesday focused on his pullback from attacking the stock market. Or at least targeting the stock market as a credit policy guide.

It was also noteworthy that our economic planner-in-chief did not attack rising productivity as an inflationist development that must be stomped on. Responding to a tidal wave of criticism both from within the Federal Reserve System and from outside commentators, Mr. Greenspan omitted the usual productivity attack from his speech. This is progress.

However, there was something even more important in the White House talk. Something that hints at a financial price rule approach to monetary policy. Here is the relevant section.

"Real interest rates on corporate bonds have risen more than a percentage point in the past couple of years. Home mortgage rates have risen comparably. The Federal Reserve has responded in a similar manner, by gradually raising the federal funds rate over the past year. Certainly, to have done otherwise to have held the federal funds rate at last year's level as credit demands and market interest rates rose would have required an inappropriately inflationary expansion of liquidity. It is difficult to imagine product price levels remaining tame over the longer haul had their been such an expansion of liquidity. In the event, inflation has remained largely contained."

Aha. At long last, the Great One concedes that inflation is a monetary phenomenon. Too much liquidity, in relation to the economy's liquidity demands, causes inflation. This is real progress. It puts monetary policy back into the Friedman-Hayek-Mundell analytical framework.

Actually, if the Fed is using "real" corporate bond rates as a policy guide, they are right in line with the spirit of a Mundellian price rule. The Mundell rule prefers gold and the dollar exchange rate as monetary value reference points, but using a financial market target goes part of the way toward the Mundell approach. At least it's a market indicator, rather than the goofy Phillips Curve, or the dopey NAIRU, or the inaccurate rear-view mirror GDP targeting of economic growth. The good should never be the enemy of the perfect.

However, I don't agree that high-powered liquidity supplied by the Fed has been excessive over the past few years. Really, excess money occurred only in last year's fourth quarter in order to guard against emergency Y2K-related cash demands. This excess liquidity was withdrawn in the first quarter, as the Fed made good on its promise to let the repurchase agreements expire. As a result, the rise in long-term Treasury rates that occurred late last year has been reversed. Ditto for gold, which has fallen back $280. Temporary inflation fears have evaporated.

Turning back to Mr. Greenspan's real corporate bond rate, it has essentially been flat since early 1999. Over the past three years, this rate has moved up by roughly 150 basis points, to about 6.25 percent from 4.75 percent.

The methodology in determining this so-called real rate is straightforward. Take the market rate on Baa-rated corporates and subtract the spread between 10-year Treasuries and 10-year inflation-indexed Treasuries (TIPS).

The major upward move in this measure occurred during 1997 and 1998. But there was no excess money, nor any leap in gold, nor any reported inflation increase. So this real corporate bond business is not much of a liquidity or inflation barometer.

However, at least it is a financial price, though the wrong price. Anyway, the corporate bond real yield has on balance increased by 25 basis points more than the 125 basis point fed funds rate move to 6 percent from 4.75 percent.

So, if we take Mr. Greenspan at his word, then the one-quarter of a percentage point rise in the fed funds target expected at the next Fed meeting in May could be the last in this tightening cycle.

Long-term Treasury rates have fallen substantially, and corporate bond rates likely will follow suit in the not-too-distant future. The real rate spread between 10-year Treasuries and TIPS has also narrowed. All this implies declining inflation expectations and, probably, a slower rate of future economic growth.

So it is possible that the Fed's tightening work is nearly over. At any rate, we will continue to use this real corporate bond yield as an analytic tool to gauge the Fed's actions. And the chairman's truth-telling to the public.



Lawrence Kudlow is chief economist of CNBC.com and Schroder & Co. Inc.

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