It's spelled m-o-n-e-y

Larry Kudlow
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Posted: Jun 27, 2003 12:00 AM

On the day after a somewhat confusing action by the Federal Reserve -- an inside-the-box quarter-point cut of the overnight interest rate -- most of the stock market action was positive.

On Wednesday, the day the Fed announced it had lowered the federal funds rate by 25 basis points to 1 percent, stocks fell. But Thursday they recovered. Information technology led the way, a sign of rising economic expectations. Healthcare came in second, suggesting that investors are still not frightened by Congress' attempts at Medicare reform. Financials, another pro-growth indicator, was among the leading sectors.

Treasury bonds, however, got whacked again. The bellwether 10-year note climbed all the way to a yield of 3.5 percent. Only 10 days ago, it was about 3 percent. Some of this sell-off reflects a disappointment that the Fed did not launch a shock-and-awe liquidity-adding program, like the one Alan Greenspan recently floated when he said the central bank could start to purchase 10-year bonds. This policy move would have given the Fed one more way to pump new cash into the pipeline.

But some of the bond sell-off could also reflect improving economic-growth expectations as the Fed continues to be accommodative.

We needed shock-and-awe-level accommodation on Wednesday -- in the form of a 50-basis-point cut of the fed funds rate or a liquidity-adding policy shift away from the Fed's ongoing interest-rate targeting. But the fact remains that a 25-basis-point cut of the funds rate represents a 20 percent easing move.

While overall monetary trends remain disappointing, with no clear sign that we are well into reflationary territory, the monetary base over the past two months has increased by 11.5 percent at an annual rate. If the Fed keeps this rate of liquidity expansion going for another six months, it would surely help to wipe out any deflationary threats. This new cash would also help finance the largest investment-oriented tax cut in decades.

The dollar and commodity prices are sending out mixed signals today. We're not necessarily out of the woods. The dollar exchange-rate continues to be firm -- it now stands at 1.14 euros and 119 yen -- confirming expectations for growth. But the price of gold, perhaps the strongest reflation indicator, is now falling back to $344. This is very disappointing; not long ago, it was riding between $370 and $380. Industrial metals have also stalled in commodity land.

Transaction demands in a rising economy -- including the investment tax incentives and a new spate of Wall Street deal-making activity in software, biotech, entertainment media and financials -- must be accommodated by the Fed. So perhaps the Fed's latest rate cut will be associated with a significant liquidity buildup. Perhaps there will be a continuation of rapid monetary-base growth.

But these are not certainties. Once again, the Fed has left everyone guessing.

Oddly, coverage of the Fed's latest move in the three leading newspapers -- The Wall Street Journal, The New York Times and The Washington Post -- never mentioned the word money. M-O-N-E-Y. And it's the creation or destruction of money that is the Fed's primary job.

It was too much money chasing too few goods that caused the inflation of the 1970s, and too little money in relation to the availability of goods that has caused the deflation of the last few years.

Newspaper writers, listening carefully as Fed staffers whisper in their sensitive ears, are blaming deflation on subpar economic growth, and they say the lagging economy has created a growing "output gap" between potential and actual economic activity. But we learned painfully in the 1970s that inflation can coexist with recession. Milton Friedman coined the term "inflationary recession," which then became known in the media as stagflation.

Then came Reagan advisors Arthur Laffer and Robert Mundell. They argued for monetary restraint as a cure for inflation and significantly lower tax rates to produce an economic recovery. This supply-side mix is just as important today. The cure for deflation is monetary expansion. And yes, the recipe for economic growth centers on more tax-rate reduction.

This week's action from the Fed seems to suggest that they will not be raising their target interest rate for a long time. This should mean that open market operations will keep the money spigots wide open. If so, this is very good news. President Bush has sponsored a huge tax cut. The Fed must support it. It must keep showing us the money.