2/19/99 - OPINION: Zero Inflation Is a Primary Cause of Strong Growth
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Feb. 19 (Bridge News)--By Lawrence Kudlow, chief economist of American Skandia
SHELTON, Conn.--Commodity prices are breaking down everywhere, the Bridge Commodity Research Bureau index has dropped to a twenty-four year low and King Dollar is showing new strength.
This signals deflationary pressures in the world economy, including the United States. It also implies a strong commodity value of U.S. money, a favorable omen for lower future interest rates and inflation.
The Federal Reserve may actually be guilty of creating too few dollars, not too many.
A bunch of market gurus are filling the airwaves with the usual Phillips curve blather that strong growth will drive up inflation and interest rates. So the Fed is edging toward tighter money. So then bond prices fall and the stock market is threatened. Yada, yada, yada. Don"t believe a word of it.
Here"s an interesting set of facts: Over the past three high growth years, when real gross domestic product advanced at a 3.9 percent annual rate, inflation averaged a measly 1.4 percent.
However, over the prior five low growth years, when real GDP averaged a measly 2 percent, yearly inflation averaged 2.8 percent.
THE MORAL of the story? Large numbers of people working and prospering is a good thing. Especially in the context of a sound currency and technological investment.
Don"t believe the Charles River crowd from the People"s Republic of Cambridge, Mass. Growth and inflation are negatively correlated. Rising growth is usually associated with declining inflation.
Dismal economic scientists may not get it, but zero inflation is one of the primary causes of strong growth. Think of it as a big tax cut for the economy.
Turning back to the commodity story, hard assets are getting whacked again. Gold, silver, platinum, copper, soy beans, wheat, corn, cotton, orange juice, coffee, heating oil and natural gas -- the whole nine yards.
TAKE A LOOK at unleaded gasoline, now priced around 34 cents a gallon on the futures market. Of course the spread between the $1 pump price and the open market price is mostly made up of federal, state and local taxes.
If we could just get a tax revolt going in this country, then all you gas-guzzling Chevy Suburban owners could fuel up three or four times a week.
The overall CRB composite index has dropped 20 percent over the past year. Among its subcomponents, industrials have lost 22 percent, grains 25 percent, precious metals 12 percent and energy 30 percent. None of this suggests rising inflation. Nor does it imply a booming industrial and manufacturing sector.
Over the past 15 months the rate of increase of industrial production has slumped from nearly 7 percent to less than 2 percent (though computer and office equipment output is still raging, with an increase of 49 percent).
FROM MY vantage point, gold is still the mother of all inflation indicators, the best measure of the value of money. I"m not advocating a return to the classical gold standard. Ordinary people around the world are thirsting for scarce dollars, not gold.
But gold is the ultimate yardstick of value, the historic unit of account. Its 30 percent drop, from over $400 per ounce in early 1996 to nearly $285 recently, has fallen in tandem with the CRB (also 30 percent down in this period).
Both signaled declining inflation in this period of rising growth. And both signaled falling interest rates.
DESPITE NEAR-HYSTERICAL fear-mongering by Phillips curve advocates and monetarists over growth spurts in early 1997 and again in early 1998, interest rates went down, not up. On balance, 30-year Treasury rates dropped from 7 percent to 5 percent in this high growth period.
Gold and commodities correctly signaled these bond rallies in advance. As a matter of fact, they are still signaling lower interest rates.
These market price indicators suggest that long-term Treasuries could fall to around 4 1/2 percent, from today"s 5.38 percent level. (Statistically, the coefficient of correlation, which measures the link between two variables, is about 65 percent between the CRB and long-term Treasuries, but less than 35 percent between gold and the bellwether Treasury.)
Commodity indicators not only outperform economic growth and unemployment as inflation forecasters, they also out-predict monetarists" M2. This money supply measure is really a reflection of the demand for money.
HARD-CORE Milton Friedman monetarists don"t seem to understand the significance of dollar demand shocks emanating from foreign currency implosions, the oil price collapse, technologically-linked productivity increases and a 20 percent rate of return on U.S. investments".
Each event has increased the willingness and desire of people at home and abroad to hold dollars. For every $100 of newly-created greenbacks, probably $75 are exported overseas. So the Fed has to keep adding liquidity merely to replenish the export of U.S. dollars.
Also, since money market deposit accounts have zero reserve requirements nowadays, people are making great use of this tax-free component of money. This bloats M2, a measure of money supply. If the 9 percent yearly growth rate of M2 were truly excessive, then gold and commodity prices would be soaring. But they"re not.
That is because, on the margin, new money demands in the marketplace are rising faster than the new money supplied by the Fed.
ACTUALLY, high-powered monetary base growth (properly adjusted for reserve-diminishing sweep accounts), the only money supply aggregate controlled by the Fed, is growing by only 6 1/2 percent, much less than M2.
A case can be made that money is scarce, not excessive. That is, in relation to continuously rising demand, the Fed needs to supply even more dollar liquidity.
Later this year, concerns over the Y2K problem may contribute yet another demand shock to the monetary system, adding more logic to the argument for additional Fed dollar creation.
The key point in all this is the commodity signal. It must not be ignored. Market prices always contain more useful information than money supply flows or government economic statistics.
Austrian economist Friedrich Hayek taught us that the free market is a discovery process. Right now we are discovering that money may still be too tight, and deflation is still in the air.
LAWRENCE KUDLOW is chief economist of American Skandia Life Assurance Inc., a Connecticut-based financial services firm, author of "American Abundance: The New Economic and Moral Prosperity" (Forbes) and was associate director for economics and planning in the Office of Management and Budget during Ronald Reagan"s first term as president. His views are not necessarily those of Bridge News.
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