Sunday, June 7, 2009


Testifying before the House Budget Committee this week, Federal Reserve Board Chairman Ben S. Bernanke said that when the time comes, the Fed will raise interest rates in order to stop inflation from building in the next recovery.

He also asked for “fiscal balance” to sustain financial stability. On the surface - in terms of keeping prices stable and restoring value to the softening U.S. dollar - this is positive. Surely Mr. Bernanke wants to do right for America, and he is giving it his best shot.

But when you talk to traders and economists, the whispered story is that Mr. Bernanke and the Fed are no longer truly independent of the Obama White House and Treasury. As a result, Mr. Bernanke will not be able to slow the printing presses and gradually lift the near-zero target rate in a timely and effective manner. Already the Fed has created more than $1 trillion in new cash, and M2 money-supply growth is the fastest in 25 years.

This monetary explosion explains what’s really driving the dollar down and Treasury rates up (alongside rising gold and oil prices). It’s not huge budget deficits, but the growing fear that a less-than-independent Fed will keep pushing new money into the financial system to fund President Obama’s liberal spending policies.

This week, German Chancellor Angela Merkel launched a broadside against the Fed, saying she views the Fed’s powers “with great skepticism.” It was an important rebuke. Here’s the elected leader of a major country telling a central bank to stop the printing presses and avoid creating yet another inflationary bubble during the next recovery cycle. In other words, it’s the printing presses, stupid.

Rising inflation and interest rates are always a monetary problem. When Vice President Dick Cheney said a few years ago that deficits don’t matter, he was basically right. There is no clear relationship between budget deficits, inflation and interest rates. In fact, for most of the ‘80s and ‘90s and much of the 2000s (excepting the 2003-05 bubble), interest rates and inflation fell while deficits averaged more than $200 billion a year and got as high as 6 percent of gross domestic product (GDP) at some points. This is because previous Fed Chairmen Paul A. Volcker and Alan Greenspan restrained money-supply growth in a noninflationary manner.

Now surely today’s $2 trillion deficit - which is 13 percent of GDP and likely to remain very high - is a shocking number. But if the Fed refuses to monetize the deficit, inflation will stay low, and long-term interest rates will normalize. Conventional economists and most politicians do not understand that excess money is the root cause of inflation, spiking rates and a bad, unwanted dollar.

Unfortunately, with the Fed purchasing Treasury bonds, mortgage-backed securities and other asset-backed bonds, the growing suspicion is that Bernanke and Co. are too entangled in Obama economic policy. Therefore, a timely Fed exit strategy is just as unlikely as a timely fiscal exit strategy to remove unnecessary budget spending and money assigned to the Troubled Asset Relief Program (TARP).

With clear signs of economic recovery on the horizon, some now call for ending the unnecessary stimulus package and de-TARPing across the board. Along with a big rise in the money supply, there have been a rebound in commodities, a stabilization in housing, falling unemployment claims, a booming stock market, narrowing credit spreads and rising Institute for Supply Management manufacturing reports. All this tells us additional stimulus is unnecessary.

Economic blogger Scott Grannis says, “Recall the stimulus.” Professor Russell Roberts of George Mason notes that just $36 billion of the stimulus has been spent through May, out of a total $787 billion. And USA Today reports $209 billion in countercyclical automatic safety-net stabilizers - which is apart from the stimulus package - already has been spent on unemployment insurance, food stamps, Medicaid and early Social Security retirements.

On the eve of recovery, with all this prior spending, why do we need more?

Policy analyst Dan Clifton tells me the $200 billion spending increase scheduled for 2011-19 definitely should be rolled back from the Obama stimulus package before it is built into the current-services spending base line. And let’s not forget that the Obama Democrats already have passed a $400 billion omnibus spending bill for 2009. So anybody in Washington who is serious about spending and deficits can save hundreds of billions of dollars by rolling back the stimulus package and TARP. The financial system is healing, and banks want to pay TARP down anyway.

Here’s the moral of this story: Excessive Fed pump-priming and over-the-top federal spending is what matters, not the budget deficit. If we keep paying people not to work by piling on more transfer payments and government subsidies, economic growth will suffer mightily. And if the Fed continues buying bonds issued by Uncle Sam, inflation will ratchet higher.

Republicans, are you listening? Roll back the unnecessary stimulus and restore the Fed’s independence.

Lawrence Kudlow is host of CNBC’s “Kudlow & Company.”

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