Magic test

Larry Kudlow
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Posted: Jan 30, 2004 12:00 AM

Out on the campaign trail, Gov. Howard Dean has criticized Federal Reserve chairman Alan Greenspan for being "too political." Dean argues that Greenspan should be harping on Bush budget deficits and opposing tax cuts. Like so many Deanisms, this charge is whacky. Greenspan was in fact an obstacle to Bush's tax cut last May. At the time, the estimable Fed leader was worrying publicly about budget deficits, even though his emphasis has always been on spending restraint rather than higher taxes.

Dean's Fed attack may have legs, but for different reasons. The little-known fact is that Greenspan's job as chairman of the Federal Reserve Board is up for renewal this summer. While his seat as a board member doesn't expire until 2006, a decision on his reappointment is scheduled to be made in six months.

As events would have it, the Fed's most recent policy statement on interest rates removed the term-of-art phrase "considerable period" and inserted in its place the word "patient." Financial markets took this to mean a Fed rate hike has been brought a little nearer. Actually, futures markets are predicting a minor one-quarter-of-a-percentage-point increase in the fed funds policy rate sometime this summer. That's about when President Bush will decide on Greenspan's reappointment fate.

But Greenspan's reworking of the Fed's policy language may have been a brilliant move. Just the mere hint that a rate hike could come in mid-2004, instead of next year, caused the beleaguered U.S. dollar to appreciate. This in turn knocked the gold price down nearly $25 to around $400 -- a much more comfortable level, suggesting a diminished risk of higher future inflation. And while broad commodity indexes have had quite a run, these raw-material indicators are simply recouping prior losses and responding to huge industrial demands from the economic booms in China, the rest of Asia and the United States.

Yes, the stock market has been selling off since the announced change in Fed rhetoric. But after a continuous rally since early November, stocks were probably due for a minor correction anyway.

Keep in mind, part of the reason why the Fed is preparing us for an earlier rate rise is the positive economic story. Second-half real growth for 2003 has come in above 6 percent, with more of the same expected this year. Business profits are also coming in above expectations, productivity is gaining rapidly, and thanks to President Bush's last round of tax cuts, business investment spending is surging. Even exports are coming on strong.

Bush told a White House meeting of economists that "the U.S. economy is strong and getting stronger," just as he urged Congress to make his tax cuts permanent and pledged to cut the deficit in half in five years. There's nothing on the Fed's plate that will disrupt this scenario -- certainly not a tiny rate hike this summer.

In political terms, however, the stock market looms as an important influence on the election. The risk of even a minor Fed rate hike a few months before the November tally might lead investors to assume that a string of interest-rate increases are coming. With 95 million shareholders in the United States, and at least 164 million stock market accounts (up from only 20 million in 1988, according to the Investment Company Institute), there can be no doubt that the market's mood running up to November will have a big impact on the voting-booth decisions of investors.

In the 2000 presidential race, stocks slumped most of the year. The onset of the bear market substantially undermined the solid Clinton-Gore economic growth record, and helped elect George W. Bush. This time, any decisive market losses -- such as a 15 percent downward correction -- could jeopardize Bush's re-election shot, even though he is clearly the pro-investor candidate. How could he not be? His large economy-boosting tax-cuts on dividends, capital gains, upper-bracket income and small owner-operated businesses are exactly the tax measures that John Kerry and the other Democrats intend to repeal.

So, this is the political tightrope that Alan Greenspan will have to walk. His re-nomination at the Fed as well as the election itself may be up for grabs.

And yet, with core inflation less than 1 percent, the economy on a tear and job-creation set to explode, the question remains: Is any Fed tightening necessary this year? Or, if the Fed decides that a minor rate hike is necessary this summer, will it be able to sell it in a non-threatening way, so as to not upset the politically powerful stock market?

The so-called Greenspan Standard will be put on full public display during the political season. The Fed chairman's magic touch will be tested as never before.