Thursday, May 24, 2001

With its two most recent credit easing moves in April and May, the Federal Reserve has acted forcefully and decisively to end the 17-month-long liquidity deflation that it had previously inflicted on the economy and the stock market. Finally, the central bank has removed a key obstacle to recovery.

By pushing the key fed funds policy rate down to 4 percent, below the two-year Treasury note (4 1/4 percent) and just above Treasury bill rates, the central bank has restored the all-important Treasury yield curve to a more normal upward-sloping shape. This sets the stage for a more normal liquidity creation process.

For most of last year, the Fed mistakenly ignored the recessionary message of the negatively sloped Treasury curve. It was their biggest blunder in a decade, leading to severe economic costs in terms of massive wealth destruction, curtailment of the productivity-enhancing technology investment cycle and rising unemployment.

Now, in response to the Fed´s first genuine stimulus move, stock markets are rallying in anticipation of a business revival sometime in the next six to 12 months. This rally will likely continue, especially if federal policy-makers enact pro-growth tax cuts and energy production policies that improve the outlook for a 4 percent to 5 percent recovery pace in 2002 and 2003. Along with easier money, lower tax-rates (especially on capital) and more reliable power supplies are essential ingredients for a strong cyclical upturn.

Liquidity additions: Federal Reserve actions are already replenishing much-needed financial liquidity. Over the past three weeks the monetary base has spiked up by $12 billion, or nearly 2 percent. This reversed its recent near-term contraction and moved base growth over the past two months to a respectable 5.6 percent annual growth rate.

Year-over-year, base growth now stands at 4 percent, probably headed for 6 percent before long, a rate that should be adequate to finance solid economic recovery and a return to business profitability during the first half of next year. The monetary base is comprised of bank reserves and currency created solely by the Fed through net purchases of Treasury securities. The base is the basic measure of high-powered liquidity.

Time to pause: At this point, the Federal Reserve would be wise to pause in its easing actions and take stock of new developments in the financial landscape that suggest the central bank has done enough for now.

Commodity and bond markets are sending precautionary signals to the central bank. Since early April the gold price has jumped nearly $25, and the S&P gold stock index has mounted an impressive 38 percent rally, much stronger than the 12.5 percent rise in the overall S&P 500 index. In a longer-term context, gold stocks are still near the bottom of a 20-year trading range. However, their recent reawakening is an important market price signal that central bank policy has now turned expansionary.

Additionally, the inflation expectations spread between 10-year Treasuries and 10-year inflation-indexed Treasuries has widened, while 10- and 30-year bond rates have increased by roughly one-half of a percentage point.

Let markets guide policy: After a brutal 17-month period of monetary deflation, it is highly unlikely that future inflation rates will go anywhere but down.

However, the Federal Reserve should heed the precautionary signals from gold and bonds that the expected reflation of liquidity is sufficient for now. An unexpected lurch from pillar-to-post, from slamming on the brake to slamming down the accelerator, would be a very unwise move that would threaten economic recovery with inflated interest rates and massive commodity speculation.

Forward-looking market prices are better guides to monetary policy than rear-view mirror data on GDP or uninformed trade-offs between economic growth and inflation. Indeed, it was the Fed´s decision last year to ignore market price signals, including sinking gold and an inverted Treasury curve, that led to the gross mismanagement of the money supply and the resulting economic slump. That painful recessionary mistake must not be compounded by even greater errors in the future that could undermine economic growth for years to come.

Lawrence Kudlow is CEO of Kudlow & Co., LLC, and CNBC’s economics commentator.

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