Lessons of the Summer Swoon

By Lawrence Kudlow (Archive) · Tuesday, August 17, 2010

The economy is suffering from something like a summer swoon. In the words of business columnist Jimmy Pethokoukis, the recovery summer has gone bust. We all know this from the sloppy statistics coming in for jobs, retail sales and, most recently, manufacturing. But market-based indicators are telling the same story.

Let's start with the Treasury bond market. Yields have fallen to 2.6 percent today from 4.1 percent last April. Decomposing this Treasury rally shows that real yields have dropped 79 basis points, which is a signal of lower economic expectations.

Meanwhile, inflation break-even TIPS (Treasury inflation-protected securities) have fallen 64 basis points, showing that price expectations also have dropped. The consumer price index has only risen 1 percent over the past year. And long-term inflation fears have fallen all the way to 1.7 percent. It's not deflation. It's disinflation.

The corporate-bond market shows a similar decline of economic-growth and profits expectations. Credit-risk spreads are widening. The spread between investment-grade corporate bonds and risk-free Treasuries has widened by 62 basis points, while higher-yielding junk-bond spreads have increased by 138 basis points.

Now, all these bond-market indicators don't tell us a whole lot about the future. But they are corroborating the summer slump in the present. Lower inflation is a good thing, but lower growth is not.

And here's another hitch in the story. Using the break-even TIPS, the Federal Reserve's zero target rate is really minus 1.7 percent, which is the same sort of negative real interest rate we had in the early and mid-2000s. This is undoubtedly why Kansas City Fed President Thomas Hoenig is worried about a new boom-bust cycle.

Hoenig calls the Fed's latest decision to maintain the zero-interest-rate target a "dangerous gamble." Those are strong words of criticism leveled at Ben Bernanke and the other Fed bigwigs. Hoenig says the financial emergency is over and predicts a modest economic recovery that requires small increases in the Fed's target rate -- still accommodative, but slightly less so.

Hoeing also echoes the fears of Stanford economist and former Treasury official John Taylor, who argues that the Fed is keeping its target rate too low for too long, just as it did between 2002 and 2005.

Are we doomed to repeat the boom-bust cycle? Very few people agree with Hoenig and Taylor. But one market that does is gold. While bond rates have been declining this summer, gold has jumped $100, and it is hovering near its all-time nominal high. That's food for thought.

And let me repeat my own mantra: The Fed can produce new money, but it cannot produce new jobs. Fiscal policy -- and its threat of overtaxing, over-regulating and overspending -- is what's ailing the economy. And that threat is reverberating through stock and bond markets. (The stock market, by the way, is still about 11 percent less than its late-April peak.)

So the long-run message of the gold rally may be this: The Fed may print too much money, but taxes and regulations may hold back the production of goods and services. And if too much money chasing too few goods is inflationary, then lower taxes and regulations to encourage more goods would promote stronger prosperity and domestic price stability.

Free market and supply-side father Robert Mundell argued for lower tax rates and stable money. Is anyone listening?

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