- The Washington Times - Thursday, September 23, 2004

You have to give the Federal Reserve some credit. The central bank typically goes off-line by targeting things they shouldn’t instead of the things they should. Rather than base their monetary decisions on real-time market-price indicators — like the value of the dollar and Treasury-market interest rates — Greenspan & Co. too often target real economic variables such as jobs, unemployment, or nonexistent Phillips Curve tradeoffs between economic growth and inflation.

This approach has frequently knocked out economic growth, as in 2000 when massive monetary mistakes totally deflated the technology boom and the stock market.

Yet, while Fed rhetoric on policy targets hasn’t improved that much, the actual results of this year’s rate-increasing have so far been good. For example, while short rates have gone up, long rates have actually come down. This suggests some small Fed rate-increases at the curve’s short end have actually reduced bond yields on the long end.

Rising short rates and falling long rates is known as the “monetary paradox.” In theory, this suggests Fed removal of excess money with an increase in the base target rate from 1 to 13/4 percent has reduced inflation fears, according to falling bond rates. Since domestic price stability should be the Fed’s No. 1 goal, it would appear Greenspan & Co. is doing the job.

One of the biggest surprises this year is that Wall Street bond bears have been completely wrong. Instead of spiking up, Treasury bond rates have actually fallen from nearly 5 percent to almost 4 percent. This has also bolstered housing, with a surprise drop in mortgage rates.

Meanwhile, the broad S&P; 500 stock index has risen slightly this year by almost 1 percent after a 26 percent increase last year. And though buffeted by rising energy prices, the core gross domestic product (excluding miscalculated trade deficits) has still grown at 41/2 percent annualized. While consumer spending has been pinched by a big jump in gas prices at the pump, business investment has more than taken up the slack.

Many observers argued the central bank would not dare raise its target rate during an election year. But the idea political pressures can unduly influence the independent central bank has again proven wrong. The Fed was overstimulative in 2003 and is removing the excess money in 2004 — election or not.

More evidence of Fed success can be seen in the rising value of the dollar. Relative to foreign currencies, gold and broad commodity indexes, dollar value has appreciated roughly 5 percent. On balance, over the course of this year, the Fed’s supply of bank reserves and currency in circulation has declined somewhat — from nearly 6 percent annual growth to just more than 5 percent as measured by the adjusted monetary base.

Inflation readings have slowed markedly in recent months from a brief bump up last winter. Presently, the core consumer price index is 1.7 percent higher than a year ago, with the chained index of the core CPI only 1.2 percent ahead of August 2003. With a historically low 5.4 percent unemployment, it is clear low inflation, relatively high economic growth and low unemployment can peacefully coexist.

It is also clear supply-side tax cuts that lowered marginal rates on work effort and investment (investor dividends and capital gains) helped spur economic growth. At the same, the tax cuts have held down inflation by production of more goods and services to chase the existing money supply. In other words, more money is countered by even more growth.

Keynesian economists should take their Phillips Curve models — that incorrectly trade off growth and prices — and bury them once and for all in the dustbin of history. While they’re at it, these apostles of government planning should also finally acknowledge that, while short-term interest rates are heavily Fed-influenced, long-term rates are completely at the mercy of market forces and their expectations of future inflation. Temporary budget deficits don’t drive up long rates, but inflationary money does.

So, as expected, the Fed raised its key interest rate a quarter-point this week. That was the right move. But now would be a great time for the Fed to take a pause. Inflation is virtually nil, economic growth is solid, unemployment is low, and the classic monetary paradox of rising short rates and falling long rates is a positive development. If it ain’t broke, don’t fix it. The maestro should take a rest.

He has earned it. That’s right. The Fed got the story right this year. The scoreboard should read: Fed 10, Critics 0.

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

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