Big Ben's good beginning

Larry Kudlow
Posted: Feb 18, 2006 9:05 AM

Call it the Bush-Bernanke rally.

 After two days of congressional hearings, new Federal Reserve Chairman Ben Bernanke delivered a "not-too-hot" and "not-too-cold" testimony that reassured financial markets -- driving up share prices by roughly 1 percent across-the-board, while gold, bonds and the dollar held flat.

 On the Bush side of the rally, the Senate voted 53-47 this week in favor of extending the president's investor tax cuts on dividends and capital gains. Joining in this breakthrough vote was John McCain, the senator who voted against these tax cuts when they were introduced in 2003. This is an important shift for the GOP presidential frontrunner -- and another big win for pro-growth fiscal policy.

  Even better, it seems that Bush and Bernanke are on the same pro-growth side. During his hearings, Bernanke gave the Bush tax cuts credit for the economic recovery. He also pledged to keep basic inflation around 2 percent or less as he narrated a positive view of the economy.

 Bernanke's biggest concern on the inflation front seemed to be a spillover effect from higher energy prices. But that hypothetical thought is being overtaken by events in the energy trading pits, where gasoline prices are plummeting and crude oil has dropped below the $60 dollar a barrel threshold. With energy inventories high, lower prices will pull down inflation rates in the next couple of months.

 Indeed, lower gas prices at the pump are increasing the purchasing power of consumer incomes, which have risen with steadily impressive job gains. This is what the housing pessimists are missing. Any cooling of the home real-estate market and the "cash out" income from that market is being more than offset by the job creation of healthy American businesses, low unemployment and rising incomes. In fact, while the economic pessimists can only cite the effects of warm weather in January, the reality is that the Bush tax-cut incentives continue to propel economic growth.

 Just look at the outsized gains in retail sales, new home construction and manufacturing production. Then look at the flood of new tax collections from the strong economy that has thrown off unexpected federal budget surpluses over the last two months.

 Of course, when it comes to inflation, it's critical that the Fed watch the right indicators, lest it does more policy damage than good.

 Bernanke impressed during his testimony when he referenced an important bond-market model of inflation expectations calculated from the difference between inflation-indexed bonds and cash bonds. These forward-looking bond-market indicators tell Bernanke that inflation worries are "well anchored" and that the Fed's interest rate target should stop at 4.75 percent or 5 percent, at most.

 However, Bernanke was much less impressive when he made lingering references to resource utilization and "excess" economic growth above potential. Remember, in the second half of the 1990s, unemployment dropped to 3.9 percent, while real economic growth averaged above 4 percent -- both of which occurred without upward inflation pressures. But the Fed worried about "irrational exuberance" and made the wrong policy call -- it began aggressive over-tightening that led to a generalized deflation of commodity, equity and business investment. This was Alan Greenspan's biggest mistake, predicated on a short-run Phillips curve trade-off that gave the central bank a very bad policy signal.

 Hopefully, Bernanke will stick with the bond indicators, bolstered by commodity- and currency-market signs, and will push the Phillips curve into the background where it belongs. Otherwise, this old Soviet Gosplan approach to central planning will doom the recovery cycle.

 Fortunately, Bernanke will be ably assisted by two new Fed board appointees -- Kevin Warsh and Randall Kroszner -- both of whom were unanimously approved this week by the Senate Banking Committee. Full Senate confirmation will occur in due course. As I've noted before, George W. Bush has moved the Fed's center of gravity toward free-market supply-side economics.

 Notably, Bernanke not only credited tax cuts for economic recovery, he also endorsed school choice and vouchers for better education performance. And he also contended that private market companies, not government, should underwrite terrorism risk insurance.

 It's safe to say that the "old guard" Fed bureaucracy -- led by Donald Kohn -- doesn't like this free-market assault one bit. They were the ones leaking potshots at young Warsh -- the Harvard trained lawyer, former investment banker and senior policy advisor who will be the only person in the Fed building with any real-world financial market experience and contacts.

 Contrary to the advice of Keynesian government planners, low tax rates and a rising economy are the best means to domestic price stability and prosperity. Let's hope Bernanke stays on the right side of this debate.