- The Washington Times - Friday, August 25, 2000

Since virtually everybody in the solar system agreed that the Fed would not tighten at last Tuesday's meeting, attention has been focused on what sort of policy would follow their decision to stand pat on the fed funds rate.

Consensus thinking strongly believes the monetary agency will keep its policy directive tilted toward continued vigilance over potential risks of future inflation. Probably so. To a large extent central bankers get paid to fret over potential inflation. It is in their job description.

But an interesting article last week by Boston economist Richard Salsman assesses the outlook for future rate increases and concludes that rising rates are possible but not probable. "Financial markets themselves provide far better objective forecasts of what the Fed will do not just next week, but in the next half year and in the coming year."

Mr. Salsman looks at the Fed funds futures market as a forecaster of future fed policy, and he finds only a 28 percent chance of a rate increase of 25 basis points at the Fed's Nov. 15 meeting, down from a 68 percent rate-raising chance back in mid-July.

For the Dec. 19 meeting, the futures market is currently saying there's only a 36 percent chance of a rate rise of 25 basis points, down from an 84 percent probability last July. In other words, the odds of future Fed tightening have diminished from about 4 chances in 5 to only 1 chance in 3.

Mr. Salsman also points to the spread between three-month Treasury bills and the Fed funds rate as an indicator of future Fed policy. He finds that over the past 45 years that spread has averaged 38 basis points.

When the spread widens significantly, it implies a future easing in Fed policy. However, a narrowing of the spread (especially if the T-bill rate is rising) infers policy tightening.

Assessing today's picture, where the spread is a relatively narrow 24 basis points, and the T-bill rate has been rising of late, Fed tightening is still possible. But since the spread has not turned negative (T-bill rates above Fed funds), "the chances of further, severe rate hikes over the coming year are quite slim."

In part this is a response to Alan Greenspan's July testimony before Congress, and a number of articles and speeches from other Fed sopranos that suggest the central bank is moving away from strict adherence to the non-inflationary rate of unemployment (NAIRU), or the Phillips Curve tradeoff between falling unemployment and rising inflation. Or at least the Fed is content with a 4 percent unemployment rate.

Instead of a growth-limiting policy corset, a number of Fed officials, quite possibly including Sir Alan himself, are focused on inflation-sensitive market price indicators, especially long-term interest rates, and most especially corporate bond yields.

Dissenters from the Phillips Curve orthodoxy include Cleveland's Jerry Jordan, St. Louis' William Poole and Dallas' Robert McTeer. They believe the new Internet economy will continue to throw off high productivity returns to technology investment, thereby reducing both price and cost pressures.

Also, this group believes market prices are better inflation indicators than econometric models with dreadful forecasting records, including the Fed Board staff's green book economic forecaster, which has a consistent record of wrongness in recent years (decades?).

So the reform faction is looking at the drop in corporate bond rates, which have fallen nearly a percentage point since May. This is a disinflation indicator that confirms the Fed's prior high-powered liquidity withdrawals and implies no further tightening is necessary.

Other indications of a rise in dollar purchasing power (and disinflation) include the $270 gold price, the weakness in non-energy spot commodity prices, the narrowing of the TIPs spread to less than 200 basis points, and the strength of the dollar exchange-rate index.

In quantity terms, excess money has been removed as 12-month monetary base growth has been reeled in to 6 percent recently from 16 percent last December. Monetary base growth less M2 growth (a proxy for transactions demand money) has deflated to nearly zero from 12 percent at the end of last year.

So money supply and demand have been rebalanced. Excess liquidity has been removed. No need for further Fed restraint. This confirms the favorable trend of inflation-sensitive market price indicators.

Of course mainstream Keynesian Phillips curvers are still obsessing over the possibility that more people will be working and prospering in the future, contributing to economic growth. Let 'em obsess. It will keep them occupied so they can't do any real harm outside their cubbyhole cubicles.

The big story is the Fed reform challenge to the NAIRU limits-to-growth orthodoxy. It is a rising tide of sensible monetary practices that will remove a key obstacle to future stock market advances and prosperity.

Unless some unanticipated external shock causes an upward spike in long-term bond rates, it is quite likely that the Fed tightening cycle is over.

Economic growth, be it 4 percent, 5 percent, or more, actually contributes to price stability (more money chasing even more goods) so long as the currency's value is held high. Hold that thought.

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

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