Caveat Emptor

Larry Kudlow
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Posted: Mar 22, 2007 5:13 PM
Caveat Emptor

"Gentle Ben, stocks' best friend."

That's the headline from the Bank of America’s latest credit report. I'm sure it's somewhat tongue in cheek. But it does characterize my view that the Federal Reserve, which held interest rates steady this week, is dissing inflation while preparing to ease monetary policy.

Two factors are competing here: On the one hand, inflation puffed up in January and February, an argument for Fed tightening. On the other hand, we have the sub-prime housing virus, by no means an economic positive (although it's not the economic catastrophe the mainstream media is making it out to be).

In other words, the Fed is caught between a rock and a hard place. And by changing its policy statement to neutral this week it appears to have chosen the path of least political resistance. But neutral is in effect a de facto easing -- at least from the standpoint of market perception:

"A roar went up on the trading floor when people saw the Fed's statement," said Jon Najarian, a trader at the Chicago board options exchange, in Thursday’s Wall Street Journal. And the stock market roared, too.

Gentle Ben Bernanke, stocks' best friend indeed.

But has inflation really become a worry? Economist Michael Darda, an inflation hawk, notes that inflation indicators such as gold, commodities, and foreign currencies have all rallied in the aftermath of Bernanke's statement. Meanwhile, inflation-linked bond spreads have been widening, another excess-money signal. I don't want to take the inflation threat too far, but these indicators, alongside higher inflation in the January and February reports, must be carefully watched.

Lurking behind all this is a historical footnote: It is possible to have slow growth and rising inflation -- or too much money chasing very few goods. This translates to a whiff of stagflation, which is the Fed’s worst nightmare.

Ben Bernanke is wagering that slower growth will bring down inflation, but that's not always a good bet. And if March brings another bad inflation report, the Fed will be faced with an excruciating choice. Futures markets are speculating that the central bank will ease in order to counter sluggish growth. But that bet could turn sour if the inflation indexes don’t behave themselves.

Moderate growth and declining inflation have been in control for some time now, and I don't think there's any need to desert the Goldilocks scenario just yet. There is in fact a reasonable chance the economy will surprise on the upside, as it has done so often in recent years. Take the important index of industrial production: It rose 1 percent in February. The Institute for Supply Management's real-time index for manufacturing and services registered good growth as well.

Jobs also don't appear to be a worry. The February jobs report, which was close to 100,000, was probably depressed by unusually bad weather. So when the March number comes out in a couple weeks, we could witness a big jobs-increase payback. Even the much-maligned housing sector registered a surprising 9 percent increase in February.

So, despite the sub-prime mortgage tragedy -- which to me looks more like a capital-markets issue than a recession call -- the economy has latent strength built-in. And if Congress would quit threatening to roll back today's low tax rates on investment, cash-heavy businesses might be willing to step up their capital-goods production.

Another point arguing against economic collapse is that the consumer is still plenty strong. A $3.8 trillion increase in household net worth in last year's fourth quarter leaves roughly $150 billion in consumer spending power. But that's only part of it. If you add in wages and salaries, which grew $325 billion, and home-equity loan extraction, which climbed $470 billion, today's consumer-spending war chest is roughly $945 billion.

All this ought to tide the economy over while the housing problem works itself out. As a result -- and despite current market perceptions -- the Fed may be in no rush to actually print more money through a lower federal funds target rate. If the economy performs on the upside, inflation may prove to be a very short-lived threat.

After all, the Fed has been raising rates and curbing the growth of the monetary base for three years now. At some point, that's going to bring inflation back towards the 2 percent comfort zone that Bernanke favors. The bottom line is that our monetary-policy gurus have their work cut out for them.

Caveat emptor, Fed: When in doubt, don't cut rates. Stay steady. Even though Goldilocks is sending mixed signals, the free-market U.S. economy may once again produce a surprisingly good result.