- The Washington Times - Friday, September 21, 2001

It wasn't all that much fun, but market historians are telling us we actually dodged a bullet. Victor Canto tells me that a typical past market decline following major outside shocks averaged 7 percent. Monday, the S&P; fell 4.9 percent, and the Wilshire index dropped 5.1 percent. Both outperformed the Nasdaq and the Dow, and both outperformed the historical average of past shocking declines. So let's be thankful for silver linings, wherever we can find them.

More significantly, the Fed is finally easing policy to pump in bank reserves. Prior to this, commodity and financial market evidence implied that the central bank was merely following market interest rates and the economy downward. Now it looks like the FOMC is leading the market.

The best evidence today of a true Fed-easing move was the jump in gold, which is now up $18, or 7 percent from its pre-terrorist war level. Daily evidence is scarce, but the Fed has injected more than $100 billion of "temporary" liquidity into the banking system over the past week. This does not include the credit-line swaps arrangements with central banks in Europe and Canada.

If the Fed is truly in an easing mode, the gold price should stay up for several more months. Commodity indexes should stabilize. So we'll wait and see.

But the bigger point is this: We are in a deflationary recession. In the three months to August, before the terrorist attack, the producer price index dropped 3.6 percent at an annual rate, while the industrial production index slumped 7.3 percent annually.

So the Fed should leave its so-called temporary liquidity additions in place until such time as market indicators show clearly that the stimulus is no longer necessary. And we should all remember that the central bank can add or withdraw liquidity without necessarily changing their overnight policy target rate.

I'm still a little concerned that the liquidity end of the Treasury curve remains inverted. Though the Fed announced that the fed funds policy target rate would be allowed to trade below its official 3 percent level, most trading today came in at 31/8 to 31/2, though some seemed to occur late in the day in the 11/2 to 2 percent range.

Nonetheless, the 3 percent target rate is still higher than three-month Treasury bills, which closed at 2.73 percent, and above the 2-year note, which ended at 2.94 percent (all according to the Bloomberg screen). Therefore, banks still have a "negative carry," whereby funds borrowed in the overnight market have a higher cost than the return on short-term Treasury paper.

Much more financially therapeutic would be a "positive carry," where banks borrow money at a rate that is below the return on the securities they purchased. At this point, ideally, a 21/4 percent to 21/2 percent funds rate could adequately finance short-term Treasury paper and permit banks to book the profitable spread and bolster retained earnings and capital resources.

The whole world expects a 50-basis point rate cut to 21/2 percent at the official FOMC meeting on Oct. 2. I wish they had done a hundred on Monday. But then again, gradualists will be gradualists. Drip, drip, drip.

The problem with all this dripping, however, is that it creates economic-delaying incentives. Folks try to capture the lowest possible borrowing costs before they spend or invest the incremental dollar. In the grand scheme of things right now, this is not the most important issue on the planet. I am glad Greenspan & Co. have revved up the printing presses. I'd just like them to rev a little faster.

Right now, the futures markets are predicting a 21/4 percent short-rate bottom in the first quarter of next year. Plugging this into our forecasting model, we now get a delayed recovery effect, beginning next winter. This year's third and fourth quarters now look to be negative, with an average recessionary decline of nearly 2 percent annually. The second quarter will probably be negative after all the revisions are in.

The good news? The last three quarters of 2002 could average 31/2 percent growth.

Looking for more good news? In three of the past four recession episodes, the stock market turned upward about three months before Treasury bill rates stabilized. Since the futures market is predicting a January-February bottom in short rates, the stock market could turn up sometime in the October-November zone.

That's not very long from now, perhaps about one terrorist scalp away ("dead or alive," according to President Bush). For three of the recovery episodes, the average S&P 500 rise was 34 percent. Keep hope alive.

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

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