- The Washington Times - Monday, September 19, 2005

With gold knocking at the door of $470 an ounce, a degree of uncertainty has crept into the inflation outlook, making today’s likely quarter-point boost of the federal funds interest rate more palatable.

An interest-rate increase, however, shouldn’t be the most important news from the Federal Reserve’s latest policymaking powwow. Unique circumstances call for a change in how the Fed directs its domestic policy. It must signal it will adhere to the age-old Hippocratic oath to “do no harm.”

Of most immediate concern to our central bankers are the economic and fiscal effects of Hurricane Katrina. The U.S. economy has essentially lost a city overnight, and this loss will continue to take a toll for some time. Katrina’s effects will probably slow expansion of gross domestic product by a percentage point or more in the third quarter, resulting in a real growth rate around 2 percent. Economic activity should pick up in the fourth quarter, though, as post-storm repair and rebuilding contribute positively to both output and jobs. But the key here remains to “do no harm.”

Excess money in the economy is the root cause of inflation, which to date the Fed has done a good job containing. According to the inflation model utilized by economist Arthur Laffer (which in simple terms subtracts money demanded from money supplied), the rate of excess money creation averaged 2.4 percent in both the three-month and six-month periods ended in August. Over the last 12 months, the rate of surplus money creation was just 1-1/2 percent.

This explains why core inflation remains low. The “chained” consumer price index (a k a the Boskin index, which is weighted annually), less food and energy, was up just 1.8 percent last month from August 2004. The standard consumer price index, again less food and energy, was up 2.1 percent. These basic inflation readings have been steady for 10 months.

But gold remains a core indicator of future inflation, and the recent spike near $470 an ounce demands attention. Before, gold had traded in a generally narrow range in the last nine months, with a high last Friday of $457.20 and a low of $411.10. The London afternoon fixing price had ranged from 6.3 percent above the nine-month average ($430.06) to 4.4 percent below it. That’s a fairly stable record.

Other real-time indicators also have reflected a noninflationary monetary environment. Bond yields around 4-1/4 percent remain at four-decade lows. Spot commodity prices (excluding energy and gold) have flattened and stabilized over the last 20 months. The dollar’s exchange value has risen gradually this year. Even the oil spike is abating. Sweet West Texas intermediate crude trades around $65 per barrel, 7 percent off its Aug. 30 peak. Unleaded gasoline has plunged 25 percent.

The Fed, nonetheless, has a close call. It may decide temporary loss of Gulf Coast economic output could set up an inflationary threat from too much liquidity chasing a short-term loss of goods. This could explain the recent gold price rise and might induce the central bank to withdraw excess liquidity by raising the key interest rate to 3-3/4 from the prevailing 3-1/2 percent.

Fortunately, President Bush has signaled his aversion to any tax increases to finance emergency Katrina assistance. So the tax-cut extensions for capital gains and investor dividends seem likely to pass in next month’s budget act. This pro-growth policy will be bolstered by Mr. Bush’s use of Jack Kemp’s enterprise-zone tax-and-regulation-free policies to rebuild New Orleans and the Gulf area. These measures will quickly restore private capital formation and lost output and help bring monetary policy back into noninflationary balance as the availability of more goods will absorb excess liquidity.

What is needed from today’s Fed meeting, therefore, is a recognition of our current low-inflation, post-Katrina realities. Let policymakers raise the fed funds rate to 33/4 percent if they will. But also let them recognize this economy needs no more braking. Let them issue a policy directive indicating monetary tightening has ended for now, putting the key interest rate in neutral. Let them take credit for restraining inflation by keeping money creation generally in check.

But most important of all, let them recite the central bankers’ Hippocratic oath to “do no harm.”

Lawrence Kudlow is host of CNBC’s “Kudlow & Company” and is a nationally syndicated columnist. William P. Kucewicz is editor of GeoInvestor.com and a former member of the Wall Street Journal Editorial Board.


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