Counter-Conventional
Kudlow Money Politics blog
Is the dollar too cheap? Is the Fed behind the curve? Is inflation taking off? Consensus Wall Street opinion would probably argue yes, yes, and yes. The bond bears are out in full force, marching shoulder to shoulder with the inflation hawks. And right behind them is a legion of economists who are collectively shaking their heads and muttering under their breath about trade deficits and budget gaps. See this article in IBD.
Permit me to offer a second opinion. The Bush administration has from day one adopted a floating exchange-rate policy with respect to the dollar, while the Federal Reserve has essentially pursued domestic price stability defined more or less as a 2 percent inflation target. Add to this the Bush fiscal approach of lower marginal tax-rates to promote post-9/11 economic recovery.
I submit that the policy is working. That is why the stock market has recovered by roughly 51 percent from the October 2002 low, and bond yields are hovering around 4.20 percent in the Treasury market. Buffeted by war and oil, the nation’s gross domestic product adjusted for inflation has been averaging around 3.5 percent. Profits and productivity have been strong, while inflation has been low.
Unlike the 1990’s, the star economic performers have been old economy industries like energy, steel, chemicals, basic materials, cement, trucking, railroading, etc. Tech has done well, but not nearly as well as the unsustainable performance of the second-half of the 90’s. Over-capacity in the tech sector has kept prices falling. Under-capacity in the old economy sectors has led to rising prices. It’s a new wrinkle inside strong prosperity.
The dollar has come down from unsustainably overvalued heights that caused deflation and recession from 2000 to 2002. As the greenback adjusts through free market forces it has overshot on the low side, as is typically the case during currency adjustment periods. But when measured by broad trade-weighted indexes, both in nominal and real terms, the greenback is within a few percentage points of its 10-year average and well above its 1995 low point. Inflation during this period has averaged less than 2 percent. There is no particular reason why inflation cannot average 2 percent over the next ten years at prevailing dollar index levels.
The U.S. is growing faster than most of its major trading partners -- imports and exports are growing at a double-digit pace. The current account deficit is about $570 billion, but there is no financing problem whatsoever. Over the past twelve months total private net foreign purchases of all U.S. securities, including Treasuries, agencies, corporate bonds, and stocks sums to $645 billion. The biggest winner among foreign investors has been corporate bonds. That is because company yields are attractive, and with booming profits their credit worthiness is superb.
As for the U.S. budget deficit, in recent months it is running at a $300 billion annual rate. This is about $200 billion less than estimates made a year ago, and falling below 3 percent of GDP. At 3.5 percent economic growth over the next few years, combined with additional spending restraint on domestic discretionary federal programs, the deficit will gradually evaporate.
Core inflation is rising a bit, as it should. The most recent readings on the consumer price index show a 1.7 percent basic inflation rate on a chain-weighted basis and a 2 percent rate on a straight CPI basis. This may creep up in the next six months to about 2.5 percent, as is suggested by the inflation forecasting differential between nominal and real 10-year Treasury bond rates. So a 2 percent base target rate administered by the Fed is too low from this perspective. But Greenspan is an inflation fighter and a gold- watcher. So he’ll move the fed funds target to 3 percent next year, probably sooner rather than later. I worry a bit that that may make money too tight, since the basic inflation rate in an era of high productivity and low tax-rates could well drop to less than 2 percent later next year.
Bush tax policy will be aiming squarely to reduce the multiple taxation of savings and investment. They also will seek a lower tax burden on corporations. According to a recent Washington Post article, tax reform will shield interest, dividends, and capital gains from taxation, expand tax breaks for business investment, and simplify other parts of the system including tax-free savings accounts. To pay for this they would prefer to eliminate the deduction of state and local taxes and the business tax deduction for employer-provided health insurance. This is excellent policy. Flatten tax-rates and broaden the tax base. More capital formation. It all spells more economic growth.
It also spells low inflation, a stronger dollar, and a higher stock market. This is counter-conventional wisdom from the supply-side. That’s my story. And I’m sticking to it. |
