- The Washington Times - Monday, December 19, 2005

Unlike many economists, I’ve never truly believed the Federal Reserve is really my friend, or a friend of financial markets and the economy.

True enough, I started at the New York Fed more than 30 years ago and got a good education there. But frankly, I would rather bet on America’s free economy, and the men and women who do the real heavy economic lifting by exercising their God-given talents to invent, produce, take risks, and work hard at their jobs, than bank on the Fed.

This is provided of course the U.S. government gets out of the way by allowing for sufficient after-tax rewards and incentives. Deregulate and U.S. capitalism will soar. Whether monetary or fiscal, central planning is the antithesis to prosperity.

All that said, a quick thought passed through my mind after the Fed policy meeting last week. I had just closed my eyes and leaned back while listening to some calm music, and I almost came to believe money’s high priests might base their policy on forward-looking bond indicators, exactly as they should. The question: Will friendly thoughts like this last for very long?

I still can’t forgive the central bank for decimating and deflating the bullish stock market economy five years ago, a move that temporarily ended the great productivity surge of the Internet revolution. But perhaps they have learned a thing or two, and perhaps the arrival of the brilliant Ben Bernanke as Fed chairman will be an occasion for real change.

In shorthand, the Fed’s policy statement last week strongly suggested the recent 18-month tightening cycle will soon end. They raised their target rate from 4 percent to 41/4 percent, and perhaps there’s another small move or two left. But bond-market indicators have for quite some time signaled an absence of inflationary pressures — a matter confirmed by the actual data where the basic inflation rate continues under 2 percent. Not only has the 10-year Treasury bond hovered at a half-century low of 41/2 percent for many years, but the difference between this cash bond and its inflation-indexed cousin suggests low inflation is here to stay for another decade.

More, broad-based inflation reminds me of Jimmy Carter. And despite the mainstream media’s best efforts, George W. Bush is no Jimmy Carter. Nor are these the inflationary 1970s. Lower tax rates and skyrocketing productivity are counter to inflation.

Now, some of my supply-side friends take issue with my optimistic view on inflation. They believe the recent run-up in gold prices to more than $500 an ounce signals excess money creation and much more inflation ahead. Therefore, some argue, the central bank must keep tightening and raising its target rate for at least another year.

But I believe this is a 1970s view — one that abstracts from the Internet Google revolution and the record productivity surge, and also ignores the global spread of capitalism, which has taken hold in the post-Reagan years and has increased the demand for scarce commodities across the board.

Consider: Daily average volume in the Treasury bond market runs up to nearly $90 billion, according to the Chicago Board of Trade. Gold trading, however, is well below $50 million, even in the recent rally. In other words, the bond market’s vast breadth, depth and resiliency suggest this forward-looking indicator has the most clout in the world market.

This does not mean gold is irrelevant as a monetary signal; but it does suggest the Fed is on the right track with what seems a new bond-price-rule approach to policy: The central bank seems to use the bond market as its leading real-world indicator.

In my view, this is as it should be. And if the authorities still worry about a touch of future inflation, all they need do is sell bonds from their huge portfolio to drain liquidity and bypass the unnecessary fed funds rate target altogether.

Gold may still take the temperature of global war and political uncertainty, and today it could tell us more about the threat of nuclear weapons in Iran than future American inflation.

For years, conservative economists have argued for a well-defined price rule. As the Fed moves into the Bernanke era, it looks like we’re getting one. Between forward-looking bond markets and backward-looking basic inflation rates, the central bank should be able to find the right policy that will not interfere with the day-to-day inspirations of the American entrepreneurs who have made our form of prosperous capitalism the envy of the world.

Lawrence Kudlow is host of CNBC’s “Kudlow & Company” and is a nationally syndicated columnist.



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