Since enactment of the Bush "supply-side" tax-rate reductions, economic news has been almost singularly positive, despite the fact that we have been fighting a war. For months, the only economic indicator that didn't show conclusive signs of progress was the payroll employment numbers, but now that, too, has changed. During the last three quarters, real GDP has grown at its fastest rate in nearly 20 years - since Ronald Reagan was re-elected in a landslide - growing at an annualized rate of 5.5 percent.

The Organization for Economic Cooperation and Development has recently revised upward expected real GDP growth for the United States in 2004 to 4.7 percent.

 Productivity has grown 4.5 percent at an annualized rate over the last three years, which is the fastest rate in 40 years. Corporate profits reached record levels in the fourth quarter of 2003 and increased by 29 percent in 2003, the fastest four-quarter increase in almost 20 years. New orders for core capital goods rose 4.5 percent in March, the largest increase in six months. Also, real disposable income increased at a 4.3 percent annualized rate in the first quarter of 2004.

Finally, since August of last year, the economy has created 1,113,000 jobs, according to the payroll survey, national press coverage notwithstanding. The unemployment rate is now down to 5.6 percent from its 6.3 percent peak in June 2003.

 If the economic news is so good, including forecasts for the near- and midterm, why has the quintessential leading indicator, the stock market, declined nearly 10 percent in the last three months? The quick answer is uncertainty. The only thing certain about Iraq right now is that it is creating enormous economic uncertainty. On top of that, there is considerable uncertainty about monetary policy and tremendous uncertainty about the future of fiscal policy and the fate of the Bush tax cuts following the 2004 elections.

 On the monetary front, markets clearly had been expecting the Fed to refrain from tightening monetary policy until after the November election, which set inflationary signals - i.e., gold above $425 an ounce - flashing red. Then the jobs reports began to improve, the backward-looking inflation indexes began to rise and the Fed no longer could ignore the inflation signals. In speeches, congressional testimony and Open Market Committee statements, the central bank began sending signals that interest rate hikes were probably coming well before the election.

It began looking like the Fed no longer would remain complacent in the face of mounting evidence of rising inflation, and market-based interest rates jumped up in anticipation of Fed tightening. On top of that, continuing good news on economic growth also indicated that accelerating demand for money would absorb much of the excess liquidity the Fed had been pumping out. The price of gold responded by falling back to under $400.

The outlook is for sustained, noninflationary economic growth if the Fed drains sufficient liquidity to confirm market expectations on the monetary front. The danger is that the Fed will try to set monetary policy by interest-rate targeting and raise the overnight interest rate too gradually to satisfy markets, mistakenly believing that incrementalism will be less disruptive than tightening all at once. If, as a consequence of gradualist interest-rate targeting, the Fed fails to sell a sufficient amount of bonds to absorb all the excess liquidity, markets will attempt to push the overnight rate higher than the Fed target and the Fed, perversely, will find itself actually injecting too much liquidity into the economy in order to keep the overnight rate from rising above its target. Continued...