- The Washington Times - Monday, November 20, 2000

The Fed made a blunder-headed move last week by failing to shift its policy bias from restraint to neutral. It should have opened the door to future credit-easing moves, but instead it remained pig-headed in pursuit of a discredited labor-market theory of inflation.

Actually, it should have reduced the fed funds rate, by roughly 50 basis points according to inflation-sensitive market price indicators. Market prices are smarter than Phillips curves. They are telling us that the money supply is too scarce and the central bank policy rate is too high.

But the Federal Reserve Board has gone back to the Phillips curve, grousing about perceived labor shortages. This despite a huge jump in jobless claims last week that foreshadows rising unemployment in the months ahead as the overall economy softens way below its potential to grow.

All those rumors that the FOMC recently took a Phillips curve behind the building and shot it are proving to be false. Knut Wicksell, who truly is dead, is nonetheless turning over in his grave. Real interest rates are falling, and this should be a sign that monetary policy is too tight. That's the Wicksellian price rule.

Inflation-adjusted 10-year Treasury rates have dropped 50 basis points since January. Investment grade corporate bond yields have eased about 80 basis points since May. These are disinflation signs.

If the Fed were following bond rates, then it would observe a clear easing signal from the market. If it were following other commodity indicators such as weak gold and falling industrial-metals prices, it would also observe a clear easing signal from the market. If it had a more global view of monetary policy, then it would see that the growing shortfall of dollars circulating around the world is causing a worldwide liquidity squeeze that is punishing numerous foreign currencies and stock markets.

And while the Fed keeps its head in the sand, it seems not to notice the election shock effect that has created so much uncertainty over future economic policy. Though George W. Bush has won three vote counts in Florida, Team Gore is working overtime to win in the courts what they lost in the polls.

Mr. Bush is clearly the pro-growth, pro-business, pro-energy production candidate. Mr. Gore is the big government regulator-in-chief who would stall growth, a sort of Jimmy Carter without the inflation.

While the election story drags on and on, it seems that people are consuming and investing less and less. The animal spirits are frozen. Risk aversion is overwhelming risk taking. We could be on the verge of the slowest holiday season in five years. Forecasters cannot be sure about this, but at least they can agree that rising uncertainty acts like a tax on the economy. And when you tax something more, you get less of it.

Thank heavens for the technology sector, which will prevent the economy's bottom from falling out. This is our Schumpeterian safety net. In today's industrial production report, output from computers, communications equipment and semi-conductors rose 3.2 percent for the month of October, totaling a 56 percent rise over the past 12 months.

Everything else was down. Durable goods fell, auto output fell, utilities fell and consumer goods fell. Manufacturing excluding high-tech dropped by one-half of 1 percent, registering a 1.3 percent decline rate over the past three months and a one-tenth of 1 percent drop over the past 12 months.

Earlier in the week it was reported that core production prices the PPI fell by one-tenth of a percent, including price drops for autos and computers. Core crude commodity prices have deflated at a 6.2 percent annual rate over the past three months. Did anyone say inflation?

The question is, if technology customers are slumping, can a technology slump be far behind? Fed Chairman Alan Greenspan had it right in his Mexico City speech when he argued that "any notable shortfall in economic performance from the exemplary standard of recent years runs the risk of reviving mistrust of market-oriented systems." He was particularly referring to the expansion of free trade, which may be stopped dead in its tracks if a global economic slump materializes.

The trouble is, Mr. Greenspan is not following his own advice. He has acknowledged that the new U.S. information economy's potential to grow is about 4 percent. Even the Congressional Budget Office is looking at a 3.3 percent long-run potential growth path.

But the recent $15 billion mark down of business inventories implies that third quarter GDP will come in closer to 2 percent than the original inflation-adjusted estimate of 2.7 percent. Judging by the weakness in purchasing managers and car sales, a slowdown in private business investment, a flat housing story and large increases in personal tax burdens, the fourth quarter economy looks to be no better than the third quarter and quite possibly worse. And this doesn't include the uncertainty tax from the endless voter-recount shock.

I've always believed the best central bankers focus exclusively on domestic price stability rather than countless and inaccurate pulley-and-chain formulations to fine tune economic growth. And the best leading indicators of price pressures come from the market.

This is the heart of the Fed's blunder. Instead of following downward gold prices and bond rates, the central bank is stubbornly clinging to outdated labor-market models and other misleading econometrica.

The best remedy for a below-potential 2 percent economic growth rate is lower marginal tax-rate incentives and deregulation. But at least the Fed can do its part by acknowledging commodity and financial signals that argue for the provision of new high-powered bank reserves.

Buried in the Fed's policy announcement press release, the FOMC did say that "softening in business and household demand and tightening conditions in financial markets over recent months suggest that the economy could expand for a time at a pace below the productivity-enhanced rate of growth of its potential to produce." Did anyone call for a speech writer?

At least it's possible that help is on the way. I wouldn't rule out a fed funds rate cut in December. Futures markets are predicting a one-quarter of a percent easing by next April. But April is a long time away.

Meanwhile, the 12-month growth of the monetary base has deflated to 3 percent from 18 percent so far this year. That's overly scarce liquidity. Dollar users at home and overseas need some help, and it's up to the Fed to supply it.

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

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