- The Washington Times - Tuesday, October 17, 2000

Mideast terrorism, and the threat of temporary oil supply disruption that could raise energy prices more, poses a near-term conundrum for monetary policy-makers at the Fed. And this potentially inflammable mix of money and oil, which is far more important than recent earnings reports, has been weighing heavily on the stock market for more than a month.

Think of this. Rising energy prices make an already tight Fed policy even tighter. Essentially, the economy is suffering from two tax increases.

First, Fed rate increases and liquidity withdrawals reduce investment returns and the demand for money. Hence the usefulness of money is weakened. It's a tax on money.

Second, rising energy costs generate a tax-increase effect on corporate profits and consumer spending. With a slowdown in total spending, businesses are unable to raise prices and consumers are left with less non-energy buying power.

So, as the Fed is disinflating the overall economy, rising oil prices are deflating the non-energy sector of the economy. It's a tax on a tax. Anti-growth and anti-profits. Not good for the stock market.

However, should the Fed shift course by immediately injecting new liquidity into the economy, then the monetary accommodation of rising energy prices would permit these price increases to spill over to other goods and services, generating the sort of monetary inflation that characterized the 1970s.

Such inflation would significantly raise the effective tax-rate on unindexed capital gains and choke off other forms of saving and investment which have been the lifeblood of the New Economy and its strong productivity gains.

Monetizing the energy shock would also drive up interest rates across-the-board causing another deathblow to growth. Bond and money market rates would rise by several hundred basis points, inflicting longer-term economic damage.

Hopefully, Middle East mischief will be limited and oil prices are peaking. In that scenario the stock market has exaggerated the tax-increase effects of oil and the worst case scenario won't come to pass.

Here's an important fact: oil and gas drilling rates are zooming, so new production will be coming on stream in the next three to six months and that will bring down oil and gas prices to a more sustainable level. In other words, in our deregulated economy, markets work.

Greenspan and Co. really have no choice but to wait for oil prices to bubble down a bit before they start lowering the fed funds rate. But help from the Fed is on the way.

The really good news, in fact, is that completely unlike the 1970s, bond market rates are coming down even while oil prices have temporarily bubbled up. And this means that if the Fed is pursuing a Wicksellian market price rule, then monetary policy will follow bond market rates with a lower fed funds rate before long.

Not only are the 10-year Treasury and Baa corporate yields nearly a hundred basis points below their peaks, but inflation-indexed Treasury yields are coming down. For example, the real 10-year Treasury rate has slipped to 3.91 percent from its winter peak of 4.40 percent. This cries out for a 50 basis point lower fed funds rate probably cumulating to a 100 basis point funds rate decline over the next 12 months.

Declining interest rates provide a safety net for stock market prices. They also generate a falling discount rate, which will capitalize rising corporate profits into higher share prices during the year ahead. Long-term rates are the most important discounting mechanism. If they were rising, we would all be in a lot of trouble. Because they are falling, however, the stock market story will have a happy ending.

Here's another interesting fact: According to First Call, the first 69 companies to report earnings in the S&P; 500 universe show a year-over-year gain of 23 percent. That's pretty darn good. You wouldn't know this by listening to some of the corporate pre-announcement warnings, which have created a confusing expectations game.

But the reality is corporate profits continue to rise at a good pace. Much of this comes from strong productivity gains, which are a shock absorber for both Fed tightening and higher energy prices.

In a 3 percent growth economy over the next year, S&P; profits should rise between 10 percent and 15 percent. Slower, but still rising. With declining interest rates, that will make for an unexpectedly good stock market performance.

All along I have believed stock market worries over oil were more important than these out-of-context pre-announcements that have been so hyped in the media. Ever since Saddam Hussein started saber rattling against Kuwait in early September the stock market, in its wisdom, has been discounting the threat of a bigger oil price shock.

Obviously the terrorist action in Yemen against the U.S. plays into this bad news scenario. But the real October surprise may well be that the moderate Arab nations play ball with the U.S. and keep pumping out oil.

Looking ahead, likely Fed easings will reduce the tax on money. The likelihood of lower energy prices will reduce the tax on corporate profits and consumer spending. And if George W. keeps his strong debating performance lead in the polls, then even more pro-growth tax cuts are coming.

I think it's going to be oil right.

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

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