- The Washington Times - Friday, May 19, 2000

With price reports holding steady in April, a Fed move to aggressively raise the overnight policy rate by 50 basis points can signal only one objective: a determined effort to depress economic growth.

This would ignore the fact that over the last five years the new Internet economy has generated 4 percent average yearly growth with only 1.8 percent inflation (measured by the personal consumption deflator). Information economy productivity has been running upwards of 4 percent (nonfinancial corporate output-per-hour), about the same as the current wage pace.

Rising profits and stock market price-earnings multiples have reduced equity financing costs, triggering a massive supply-side expansion through record business investment in technology and other forms of equipment. Overall capacity utilization today stands at 82.1 percent, less than the mid-1990s. Manufacturing capacity use is only 81.4 percent in the ninth year of this business cycle.

In terms of economics 101, when the aggregate supply curve shifts out, then prices fall. The Fed, however, is wedded to the Phillips Curve, a theory asserting that declining unemployment generates rising inflation.

This model has completely broken down in recent years (for the umpteenth time since World War II), as a combination of productivity-enhancing technology breakthroughs, a lower capital gains tax-rate (promoting record venture capital investment) and low inflation (to hold down long-term interest rates) has expanded the economy's long-term potential to grow.

The April price numbers, meanwhile, were pleasantly benign. On a year-to-year basis, the core CPI (excluding food and energy) registered only 2.2 percent, with an even lower 1.9 percent pace excluding tobacco. Most economists believe this index overstates inflation by seven-tenths of 1 percent, so the true inflation may be just above 1 percent. Personal computer prices are deflating by 25 percent per year.

Wholesale prices in the core PPI report scored only a 1.3 percent advance, with computers falling by 17 percent from a year ago. Other data for April show no evidence of any supply-demand imbalances in the economy. On the investment side, individual production was 6.1 percent over the prior year, led by a 42 percent rise in computer and office equipment. Nominal retail sales were a bit stronger at nearly 10 percent, but less the CPI, the 6.7 percent real sales rate was in line with production.

Meanwhile, prior Fed tightening moves have already slowed the housing sector as well as department store and general merchandise sales. Investment spending is off its peak growth rate.

The Fed has drained high-powered liquidity from the economy at a 13 percent pace, removing more than $40 billion from the monetary base. This reserve drain helps explain the rising dollar and the declining gold price. Transaction demand proxies such as MZM, M2 and M3 have been slowing in growth since early 1999.

There is always a risk that Fed interest rate increases actually cause future inflation to move higher, not lower. This is because more expensive financing costs reduce the demand for money as consumer and investment activity slows. Hence, monetary base growth (money supply directly controlled by the Fed) frequently exceeds money demand proxies such as MZM, M2 or M3 during tightening cycles.

So far this has not happened, since base money has been reduced as the Fed shrinks its balance sheet (Reserve Bank Credit) in the post-Y2K period. That is why gold remains low and the dollar is strong.

However, the danger of Fed overkill is ever-present. Should the central bank raise the fed funds rate 50 basis today and another 50 basis points in June, then the overkill threat would be that much greater, and inflation, economic growth and the stock market would be put at greater risk.

Fortunately, the stock market in recent days has performed well, however timid volume still implies that the correction has not yet run its course. Market spirits were lifted by George Bush's proposal to reform Social Security through private retirement accounts, as well as calm price reports and a cooling off of retail sales in April.

But if the Fed sticks to the Phillips Curve and insists on aggressive moves to dampen growth, production and employment, then future trouble is in the cards. Wrong models generate bad results, no matter how good policy intentions may me.

Since the early 1990s, the Fed favored use of a financial price rule approach, using gold, commodities, the dollar exchange rate and long-term bond yields to determine whether liquidity was excessive or scarce. That model kept purchasing power strong and inflation low. As the Internet revolution took hold, more money was chasing even more goods. So prices remained relatively stable.

It is to be hoped that Greenspan & Co. will not stray too far from the price rule and that they will use good common sense to understand that economic growth is a solution, not a problem. We won't realize just how good prosperity is until it is gone. This is why my free advice to the Fed is simple: Less activism is always better than more.



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

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