- The Washington Times - Saturday, November 13, 2004

As the whole world expected, the Federal Reserve continued normalizing short-term rates by raising its policy target to 2 percent last week. Since last June the Fed funds rate has doubled, but long-term rates have defied conventional wisdom by actually falling. This is a great sign that neither actual nor expected inflation is a problem.

So far in the Bush recovery cycle, the inflation worriers have been wrong. In fact, lower marginal tax rates put into action by the president have contributed to minimal inflation and sustainable economic growth.

It’s interesting that even many supply-siders have forgotten the counterinflationary impact of lower taxes. Stronger employment and higher investment are responses to lower tax rates. Therefore, increased production and economic growth are absorbing excess money and holding down inflation. Over the past year the consumer spending deflator has increased only 2 percent, while the core inflation measure (excluding energy) is a minuscule 1 percent.

The Fed is doing its part to maintain domestic price stability by gradually raising its interest-rate target and slowing new-money creation. It is also paying attention to real-time market-price signals as a guide to policymaking.

Recently the three-month Treasury bill leapfrogged the federal funds target rate and the gold price moved up to $435 an ounce. These were market signals that the Fed’s interest rate was too low and that the central bank should withdraw some money to prevent rising inflation.



That Greenspan & Co. are moving gradually but steadily to remove the emergency money-supply stimulus created after the September 11, 2001, attacks is a positive omen brightening the outlook for long-run, noninflationary growth.

Numerous pessimists littering Wall Street have also taken to gnashing their teeth over a softening dollar. For them, the glass is always half-empty. Conservative economists want the Fed and the Treasury to rescue the dollar. But this can only be done with a much more radical monetary tightening by the Fed, perhaps combined with a futile Treasury currency-market intervention policy. All this would be a mistake. It might even sink the economy.

First, the dollar is fundamentally undervalued at present. With the U.S. economic-recovery miracle continuing to build, and with the successful battle of Fallujah moving us closer to democratic elections in Iraq, the dollar is actually poised for a major rally. But perhaps only optimists can see this.

For now, the real problem with the dollar is not so much that the Fed is too loose, but much more that the euro is way too tight. Just as with foreign policy, Old Europe has the monetary story wrong. New euros are being created at a way too stingy rate that is in fact still deflationary.

Consequently, Eurozone economic growth has averaged a recessionary 1 percent in recent years, while the U.S. recovery rate has been 3 percent. America lowered tax rates, but the Europeans refused to do so. Top-heavy social spending and excessive regulation of business and labor markets also suppress Eurozone growth. Compared with the United States, Europe does not work, produce or invest — and has terrible productivity. And their monetary policy is scorched-earth deflationary. Old Europe has dug itself into a deflationary hole.

However, a number of Fed officials have worsened matters by talking down the dollar. This is dumb. They believe the large U.S. current-account deficit requires a cheaper dollar. This is also dumb. Trade deficits no more sink exchange rates than budget deficits drive up interest rates. Both currency values and interest levels are determined by monetary policy — not the so-called twin deficits.

Because of the much faster growth in the U.S. economy than in that of its biggest export customers, we are buying more from them than they purchase from us. Rapid growth in China and India over the next decade will correct our trade imbalance.

In the meantime, America’s low-tax, high-profit economy attracts private-capital inflows from all over the world. Lately, foreign inflows have come in around $600 billion, about the same as our $570 billion current-account deficit. There is no financing problem.

That said, it would be foolish if the U.S. Fed started targeting a fixed dollar-euro cross-rate. If the Europeans are stupid enough to crash their economy with overly tight money, that’s their business. But the U.S. must not make the same tight-money mistake and wreck this prosperous recovery.

Instead, domestic price stability should be the Fed’s strategic goal. So long as the U.S. central bank ties its policy to a domestic price rule — guided by financial- and commodity-market indicators — as Mr. Greenspan seems to be doing, the U.S. will continue along a noninflationary prosperity path.

Fortunately, in his final cycle as Fed chairman, the maestro remains at the top of his game.

Lawrence Kudlow is a nationally syndicated columnist and is chief executive officer of Kudlow & Co., LLC, and CNBC’s economics commentator.

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