- The Washington Times - Monday, July 24, 2000

Biting through all the dog-chasing-tail-GDP-number-crunching-Fedspeak-central-planning presented last week by Sir Alan Greenspan, there's one truly tasty morsel that can be easily digested.

Namely, it is possible that the Fed is now using long-term interest rates as their new policy guide.

And bond rates over the past six or seven weeks have been coming down. This signals lower future inflation and a less sizzling economic growth rate.

Which seems to be OK with the Fed. So one implication of Mr. Greenspan's testimony was: no Fed tightening in August. And, second, if bond yields stabilize or decline further, the Fed's tightening cycle is likely to be over.

Using bond rates for policy is a de facto price rule. Market forces, not Phillips Curve, NAIRU, output-gap econometric models, will be driving Fed policy. Is this a good thing, or what?

Another way to look at it: Mr. Greenspan, 10; main root-canal Phillips Curver Laurence Meyer, 0.

And let us give kudos to the man behind the scene, Jerry Jordan. His heartland of America Cleveland Fed annual report, which trashed the Phillips Curve, seems to be having a significant policy impact.

Now, before readers start climbing all over me for ignoring Mr. Greenspan's multipage continuous ad nauseum GDP-parsing of flawed economic information from the Commerce Department, which of course is totally inaccurate because it fails to capture the New Economy software, Internet, wireless, biotech and nano-tech, etc., I acknowledge that the Fed still has some sort of economic speed limit in mind.

But, at the margin, it is plausible to surmise that long-term interest rates are at least as important, or perhaps more important, than the speed limit.

Anyway, the Fed chairman admitted the economy (if only the old economy) is slowing. Though of course the slowdown story is, to use Mr. Greenspan's word, provisional.

The evidence on lower bond rates, however, is significant. Both 10-year Treasury and Baa corporate yields have declined about 70 or 80 basis points during the past six or seven weeks.

What is more, the so-called TIPS spread (10-year Treasury minus the 10-year inflation-indexed Treasury), a proxy for market inflation fears, has narrowed to 200 basis points from its spring peak of 250 basis points.

Prior to this, real inflation-adjusted bond rates had been rising. So the Fed reacted. In the chairman's words:

"As the financing requirements for our ever-rising capital investment needs mounted in recent years beyond forthcoming domestic saving real long-term interest rates rose to address this gap. We at the Federal Reserve, responding to the same economic forces, have moved the overnight federal funds rate up 1.75 percentage points over the past year. To have held to the federal funds rate of June 1999 would have required a massive increase in liquidity that would presumably have underwritten an acceleration of prices (italics mine) and, hence, an eventual curbing of economic growth."

I rather like this analytic from Sir Alan because at least it acknowledges that excess liquidity (created by the Fed) is the root cause of inflation. Not too many people working, prospering, producing, risk-taking, inventing or innovating. But too much money.

It could be argued this is the classic "Wicksellian" market price rule approach, whereby commodity and financial price indicators signal the central bank whether the discount rate is too low (excess liquidity) or too high (overly scarce liquidity).

If I had any say in the matter, which I don't, I would certainly add the gold price and the dollar exchange-rate index to the mix of market inflation signals. But the real long-term bond rate is vastly and extra-celestially and interplanetarily superior to Phillips Curves and NAIRUs.

So the Fed's tightening looks to be over. The futures market in Fed funds is forecasting only a 10 percent probability of a one-quarter of a percentage point rate increase in August, and a 42 percent chance of a move in October. By then, I'll bet, long-term rates will be even lower.

With the Fed stepping out of the way, an important obstacle is removed from the long-term technology-driven productivity-enhancing capital-deepening bull market prosperity cycle.

Now investors can refocus on the tax-cut revolution that is sweeping through the global economy. Declining tax-rates will improve the entrepreneurial incentive structure worldwide and lengthen the long-wave technology boom. And the stock market rise.

Good work, Mr. G, you're gaining on it.

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



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