- The Washington Times - Wednesday, July 12, 2000

No, Mr. and Mrs. average U.S. investor, I am not thrilled about the slowdown in the economy. Nor do I think the Fed's historical track record of "soft landings" is anything to write home about.

There is some good news out there. Congress is mobilizing to cut the estate tax, the marriage penalty and maybe the gas tax as well. Send the budget surplus back to the people who earned it.

And back in Fed-land, policy reform is in the air. As an offset to the Washington Fed's austerity thinking, the Cleveland Fed's recent annual report features an excellent article titled "Theory ahead of rhetoric: Economic policy for a new economy." This is a must read.

The heartland reserve bank's free-market research staff tees off on the Phillips Curve trade-off between low unemployment and rising inflation. Supervised by bank president Jerry Jordan, a former Reagan economic adviser, the article cites "The deep theoretical weaknesses" of potential output, the non-inflationary rate of unemployment and speed limits to growth.

"The concept of potential output is hollow," the Cleveland Fed asserts. "There is no fixed mapping of the rates of unemployment and inflation… . Potential output or the NAIRU cannot be made more useful concepts, even with better measurement or better econometrics."

Alban W. Phillips' model of how the economy works avoided human expectations or after-tax rate of return incentives. Instead, he constructed an economic model based on the workings of "hydraulic machines with transparent tanks and tubes, regulated by valves." Huh?

Hello Mr. and Mrs. Valve, you are now supposed to stop working and spending. All to satisfy some tenured faculty member's notion that unemployment mustn't drop below a certain threshold rate. Of course, that rate is itself a moving target. Fifteen years ago, some thought it was 6.5 percent. some studies show it could be as low as 3.5 percent.

Only a couple of years ago the Fed itself thought maximum potential economic growth was 2.5 percent. Now some Fed planners say it could be 3.5 percent to 4 percent. That's a pretty big move in only two years, don't you think? With tax-rate reduction and private investment accounts to reform Social Security, why not 5 percent yearly growth?

Mr. Jordan himself believes closed economy models of potential economic growth "can't be used in borderless worlds of commerce and finance." He added, "National GDP is not the right thing to be looking at. Also, money targeting is no longer viable."

The Cleveland Fed president has come around to a "Wicksellian natural rate" view, where commodity and financial indicators signal the central bank as to whether liquidity is scarce or plentiful. If the natural rate (real interest rate) is too low, liquidity should be drained. If the rate is too high, liquidity should be added. Key market price indicators provide the most accurate policy signals.

The main thing according to the Cleveland Fed article is that steady policies protect the future purchasing power of money. Mr. Jordan refers to this as "monetary stability," a broader concept than price stability. He greatly prefers policy rules to frequent fine-tuning episodes.

Mr. Jordan's reformist views are joined by the Dallas Fed's Robert McTeer,an apostle of the new economy, who has also argued against the Phillips Curve as a policy tool or a useful analytical device.

In numerous speeches and articles in recent years, Mr. McTeer has stated that if inflation is caused by too much money chasing too few goods, then the availability of more goods renders the existing money stock less inflationary. In other words, more growth contributes positively to stable prices and strong purchasing power.

Though somewhat less vocal, St. Louis Fed President William Poole has taken a similarly critical view of the Phillips Curve, with a like-minded emphasis on the benefits of technology-induced productivity gains.

I would like to add a corollary view: the less Fed the better. Think of this. Between the spring of 1995 and the spring of 1999 we heard very little from the monetary temple. No anti-growth actions were taken. No attacks on the economy, or low unemployment.

During that period, the economy expanded at 4 percent annually, with an inflation adjustment that averaged only 1.6 percent yearly (core consumer spending deflator). The stock market roared as economic growth exceeded virtually all expectations. Without inflation.

Now consider this. Since the Fed started its rate-raising campaign to slow the economy in the spring of 1999, the inflation rate has actually increased a bit. Measured over 12-month intervals, core inflation bottomed in mid-1999 at 1.3 percent. Today, the core inflation rate has moved up to 1.8 percent, one-half of a percent above its year-ago low. This isn't much of an issue; indeed, I call it a high-class problem. But it is interesting that after a year of rising rates, inflation has moved higher, not lower.

And economic growth is set to move lower. The forecasting consensus is looking for 3.6 percent real GDP growth in the second quarter and 3.4 percent in the third. My estimates, however, suggest 2.7 percent in the second quarter and 2.8 percent in the third quarter. Nonetheless, both these views envision a growth slowdown.

So it could be argued that Fed fine-tuning to depress the economy has succeeded in slowing growth and raising inflation. Not exactly the desired outcome. Although it happens all the time. Take a look at the '60s, when rapid growth coexisted with low inflation. Or the '70s, when sluggish growth ran alongside rapid inflation.

By aiming their guns at economic growth and stock market prosperity, the Fed has reduced the demand for money, lowered the propensity for risk capital investment, shortened investment horizons and recreated business cycle volatility in the economy and the investment markets.

So far the damage has been minimal. But to my way of thinking, the problem was non-existent in the first place. How can prosperity be a problem?

If the central bank had focused on gold, spot commodities, bond yields, and the dollar exchange index, it would not have raised rates a year ago, it would not have poured in excess liquidity last fall, so it would not have tobe draining liquidity and raising rates even more this winter and spring.

A steady price rule approach call it Wicksellian would have maintained monetary purchasing power without the side effect consequences of increased uncertainty and volatility.

The rest of the economy would take care of itself. The Internet economy is self-regulating, especially with hi-tech information processing advances that enable entrepreneurs, consumers, workers and business managers to react quickly to both opportunities and setbacks. Government planning is unnecessary and counterproductive.

Hopefully the Fed reformers sitting inside the system will be able to effect change. Certainly this old economy institution is badly in need of change.

I would love to see a Michael Dell-type new economy manager rip through the Fed, cutting out unnecessary bureaucratic layers and eliminating all the failed Phillips Curve/NAIRU/output gap models. It is time for a change. How about a little creative destruction at 20th and C Street, NW, that is, in Washington D.C.?



Lawrence Kudlow is chief U.S. investment strategist and chief U.S. economist at ING Barings LLC.

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