Larry Kudlow

Ben Bernanke threw a curveball in his midterm report to Congress this week. The Fed view of the economy has been downgraded since it last reported in February. Although the official Fed forecast for 2010-11 is still 3 to 4 percent real growth, Bernanke sounded particularly gloomy when he characterized the economy as “unusually uncertain.” And he indicated that the majority view of the Fed Board of Governors and Reserve Bank presidents is that the risks to growth are “weighted to the downside.”

But here’s the disconnect. With no inflation and weaker growth, including stubbornly high unemployment, Bernanke mostly talked about an exit strategy that would shrink the Fed’s balance sheet by removing liquidity. This was the Fed’s bias last winter when the recovery looked stronger. Now that the recovery looks weaker, the stock market was hoping to hear Bernanke hint of an easier policy that would increase liquidity if necessary. Didn’t happen.

At the end of two days of testimony, Bernanke’s message seemed to be this: Expect the zero-interest-rate policy to be extended for another year. Futures markets now predict free money until September 2011.

Whether the economic outlook is as downbeat as Bernanke suggests is an interesting question. The vast majority of corporate profit reports for the second quarter show better-than-expected earnings and top-line revenues. In other words, the CEOs are a lot less pessimistic about the future economy than Wall Street or Main Street. And a combination of strong profits, a zero interest rate, and a positively sloped Treasury yield curve would certainly seem to rule out a double-dip recession.

However, one year into recovery, private jobs should be growing much faster and unemployment should be a lot lower. Following a deep recession, economic growth should be closer to 8 percent than 3 percent.

But there are limits to Fed fine-tuning. The central bank can produce more money, but that doesn’t mean it can produce more jobs.

Look, the Fed has already injected $1.4 trillion of new money into the economy, of which about $1 trillion of excess reserves are unused and on deposit at the central bank. Putting it another way, the economy has more liquidity than it knows what to do with. What’s the problem? All that excess money is not being used. And this, I believe, is a fiscal problem, not a Fed problem.

Think of all the economic obstacles of spending, taxing, and regulating coming out of Washington. What should be done to spur growth? Keep tax rates down. And stop passing massive regulatory bills, like the bank reform Obama just signed into law.


Larry Kudlow

Lawrence Kudlow is host of CNBC’s “The Kudlow Report,” which airs nightly from 7 p.m. to 8 p.m.