More non-inflationary prosperity

Larry Kudlow
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Posted: May 26, 2005 12:00 AM
The headline number for first-quarter gross domestic product has been lifted to 3.5 percent from the so-called advance number of 3.1 percent. Meanwhile, core private-sector GDP (consumption plus business investment) has been lowered from 4.4 percent to 4 percent. In both cases the statistical differences are minor and the economic news remains good. While the 2005 economy is not necessarily bursting at the seams, the outlook remains non-inflationary and bullish. President Bush, the Federal Reserve, the business sector, and the American worker all have a hand in this prosperous cycle.

As for the all-important business sector, strong corporate profits, in particular, signal the health of this economy. Profits on an IRS income-tax basis, as reported in the national income accounts, have moved up to 10.9 percent of GDP -- the highest level since 1968. On an after-tax basis the profit share of GDP is at a post-WWII high of 8.1 percent. After adjusting for the on-again/off-again cash-expensing bonus for depreciation, after-tax profits rose 27 percent (non-annualized) in the first quarter and nearly 37 percent over the past year.

Profits are the hinge of business, and business is the backbone of jobs and the economy. With profits rising to record levels, future economic expansion is assured.

Business equipment expenditures (capex) and consumer spending have both cooled somewhat, but they certainly haven?t gone cold. Capex, after rising 18 percent annualized in the second half of 2004, increased only 5.6 percent in the first quarter, below the consensus estimate of 6.9 percent. Business inventories accumulated about $12 billion less than first estimated. And consumer spending increased only 3.6 percent, following an average 4.6 percent growth-rate in last year?s second half.

While the trade gap has narrowed, raising overall GDP growth, there are actually signs of a somewhat slower economic pace inside the basic economy. Wall Street economist Joe LaVorgna points out, however, that first-quarter wages and salaries were revised up by a huge $163 billion, with the measure growing 7.5 percent over the year-ago pace. That explains double-digit federal tax-collection returns: Lower tax-rates have expanded incomes, which are in turn throwing off more revenues. This, of course, is the Laffer-curve effect.

Core inflation is still tame, rising at 1.6 percent over the past year, about the same as the second half of last year and actually slower than in 2002. The gold price, at $418, is consistent with less-than 2 percent underlying inflation. So is the 10-year Treasury yield of 4.09 percent and a yield curve that has flattened to just over 100 basis points.

The Federal Reserve has restrained inflation expectations, and as a result long rates have descended even while short rates have moved higher. That?s a nice piece of work. Along with rising jobs and incomes, low mortgage rates will sustain the strong expansion in housing investment.

Meanwhile, the strengthening dollar, along with softer commodity prices, also suggests a benign outlook for future inflation. It looks like Fed restraining moves have broken the fever of commodity speculation, which probably means real estate prices will begin cooling soon.

The 91-day Treasury bill is currently yielding 2.93 percent on a coupon-equivalent basis. This is below the 3 percent fed funds target rate, and suggests the central bank could hold steady. However, the Fed is likely to raise its target once more by 25 basis points to 3.25 percent. The 10-year Treasury could dip below 4 percent, but at least the yield curve would remain positive. All this suggests a somewhat slower economy in the year ahead, but no real damage and certainly no recession.

Actually, we are looking at non-inflationary prosperity for several more years to come. This is a good stock market scenario where the broad indices still look to be 20 to 25 percent undervalued. In policy terms the Fed has done its job by restraining inflation and President Bush?s supply-side tax cuts have reignited economic growth. The results are unmistakably positive.