- The Washington Times - Sunday, February 25, 2001

Bad CPI and PPI reports for the month of January have sent a stagflationary shiver through the financial markets. I can buy the stag, but not the flation.

The stagnant economy is best illustrated by the continued drop ofindustrial production, which has fallen four consecutive months. Production is the single best coincident economic indicator. Two more monthly declines might well spell recession. Or, to use Vice President Dick Cheney's phrase, "the front-end of recession."

Lower tax-rates to put more cash in consumer pockets and improverewards for investment spirits and producer incentives will solve the stag problem. The more I think about the role of tax policy right now, the moreI believe that a return to our 4 percent growth potential will not occur until a good tax-cut bill is signed.

As far as the inflation threat, every commodity price on the planet is falling. Including the mother of all inflation indicators, gold, which has dropped into the $250s, a 5 percent decline year-to-date.

So it would be a great mistake if the Federal Reserve holds back on itseasing strategy just because of flukey one-month energy-driven PPI and CPI reports. If the Fed looked forward at the implied forecasts of market price indicators, instead of backward at flawed statistical reports, it would seedeclining future inflation and recognize the need to inject considerably more liquidity into the sinking economy.

Take a look at the commodity charts. Gold, silver, platinum, copper, cotton, lumber, steel, all down. Crude oil, down. Natural gas, down. New York unleaded gas and home heating oil, down. CRB futures, down.Spot CRB, down.

All this shows deflation, not inflation, in the air. Significantly, gold and commodity prices are declining even while money supply growth is recovering. Monetarists like Bill Poole of the St. Louis Fed are actually worried about overexuberant money growth. They shouldn't be. 09MZM (money of zero maturity, really the old M1 plus institutional money funds) has spurted to 15.2 percent annualized growth over the past three months,while the broader money stock M2 has increased by 10 percent.

These measures are influenced by Fed policy, but they are mostly demand-driven by private sector transaction and investment preferences.

Lately, the biggest push to these money aggregates has come from huge mortgage refinancing activities, as households rebalance and reliquefy their financial statements in the wake of lower interest rates. Also,turbulent stock markets may be inducing people to hold more cash.

The monetary base, however, which is the true supply of money directly controlled by the Fed through open market purchases of Treasury securities, is growing more slowly than transaction demand money. Base growth over the past three months has registered an 8.7 percent rate of gain, less than MZM and M2.

Therefore, there is no excess money problem that would foreshadow rising future inflation. That is why gold, commodities and interest rates are falling.

Greenspan & Co. are moving in the right direction by lowering the fed funds policy rate and expanding its creation of bank reserves, but the demand (MZM and M2) for high-powered cash (monetary base, or Federal Reserve credit) is rising faster than the supply.

Another way to see the ongoing liquidity shortage is the shape of the Treasury yield curve. As economists David Gitlitz and Marc Miles have recently pointed out, the short end of the curve is still inverted. Three-month Treasury bills yield more than two-year Treasury notes. And, as Mr. Gitlitz has pointed out, the fed funds rate still exceeds 10 and 30-year bond rates.

Commodity and financial market prices are smarter than government inflation indexes. When money supply data confirm market price indicators, the case is even stronger. There's still a liquidity shortage.

Mr. Greenspan in his most recent Senate hearing on monetary policy never spoke about inflation-sensitive market price indicators or money supply measures. Too bad. They're sending him an important message: more high-powered cash and a lower fed funds rate are necessary. The sooner, the better.

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

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

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