Sunday, June 29, 2008

On the day after an unusually important Fed policy meeting, both gold and stocks severely rebuked the central bank’s decision not to act in support of the weak dollar or to curb rapidly growing inflation. Gold rose $30, a clear message that Bernanke & Co. won’t stop inflation. Stocks plunged more than 200 points, an equally clear message that the Fed’s cheap-dollar inflation is damaging economic growth.

These market warnings are two sides of the same coin. Inflation, which is caused by excess dollar creation, is the cruelest tax of all. It is a tax on consumer and family purchasing power. It is a tax on corporate profits. It is a tax on the value of stocks, homes and other assets. Crucially, the capital-gains tax - the most important levy on all wealth-creating assets - is unindexed for inflation. Hence, long before Sen. Barack Obama or Congress can legislatively raise the capital-gains tax rate, rising inflation is increasing the effective tax rate on real capital gains. That’s an economywide problem.

By doing nothing at the June 25 meeting, the Fed turned its back on the very inflation-tax problem it helped create. The spanking it received from the markets was well-deserved.

Former Fed Chairman Paul Volcker, who is advising Mr. Obama’s presidential campaign, issued a stern warning at the New York Economics Club a few months back. He said inflation is real and the dollar is in crisis. Soon after, Fed Chairman Ben Bernanke changed his tune in public speeches, pledging greater vigilance on inflation and hinting at a defense of the dollar. Treasury Secretary Henry Paulson and President Bush also stepped up their rhetoric regarding a stronger greenback. But words were no substitute for actions.

It is an interesting historical footnote that Paul Volcker is still highly regarded as the greatest inflation fighter of our time. Working with Ronald Reagan, Mr. Volcker slew the inflation dragon in the 1980s. Indeed, the combination of tighter monetary control from the Fed and abundant new tax incentives from Reagan launched an unprecedented 25-year prosperity boom characterized by strong growth and rock-bottom inflation. At the center of the boom was a remarkable twelvefold rise in stock market values, a symbol of the renaissance of American capitalism. But that was then, and this is now.

Talk of major new tax increases is in the air today, while the inflationary decline of the American dollar is plain fact. It’s as though our economic memory is being erased, both in tax and monetary terms. Staunchly optimistic supply-siders Arthur Laffer and Steve Moore are even finishing a book on the subject. The book is titled “The Gathering Economic Storm,” its concluding chapter, “The Death of Economic Sanity.”

The Volcker anti-inflation model presumably handed down to Alan Greenspan and Ben Bernanke always argued that price stability is the cornerstone of economic growth. Yet it appears today’s Fed has reverted to a 1970s-style Phillips Curve mentality that argues for a tradeoff between unemployment and inflation, rather than the primacy of price stability.

History teaches us otherwise. It states that since rising inflation corrodes economic growth, inflation and unemployment move together - not inversely. Even in the last 18 months this is proving true. Inflation bottomed around 1 percent in late 2006. Unemployment bottomed at 4.4 percent about six months later. Today, the CPI inflation rate has climbed to more than 4 percent, wholesale prices have jumped to 7 percent, and import prices have spiked to 18 percent. Unemployment, meanwhile, has moved up to 5.5 percent.

Over the last five years the greenback has lost 40 percent of its value. Oil is close to $140 a barrel. And gold, now trading above $900 an ounce, is warning that if the Fed fails to stop creating excess dollars, inflation could rise to 6 percent or 7 percent.

I had hoped Ben Bernanke would reveal his inner Volcker at last week’s meeting. He didn’t. While the Fed acknowledged that “the upside risks to inflation and inflation expectations have increased,” it took no action taken to raise the fed funds target rate, now 2 percent and actually -2 percent adjusted for inflation. Even a quarter-point rate boost - merely taking back the last easing move in April - would have been a shot heard round the world in defense of the beleaguered dollar. It didn’t happen.

Only Richard Fisher, president of the regional Dallas Fed, dissented in favor of a higher target rate. That leaves the hard-money Mr. Fisher as the lone remaining protege of Paul Volcker.

Of course, if Fed policymakers reconvene immediately to right their wrongheaded mistake, the value of our money could be quickly restored. The next scheduled Open Market meeting is Aug. 5, but they needn’t wait that long. Let’s hope they come to their senses.

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

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