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September 19, 2007
Monetary Restraint
By Lawrence Kudlow & John Park
Consulting
Chief Economist
American Skandia
Up until yesterday’s shock and awe 50 basis points Fed rate cut,
the Fed has maintained a
Treasury Yield Curve Spread
policy of significant
monetary restraint. It is clearly shown by the
yield curve inversion, which is more than a year
old.
10-Yr less Fed Funds
250
200
150
100
The Treasury yield curve spread
(measured as 10-year less Fed funds) has been
inverted since the middle of last year and
remains inverted, even with yesterday’s 50 basis
point funds cut.
50
0
-50
-100
-150
1/7/05
7/8/05
1/6/06
7/7/06
1/5/07
7/6/07
Real GDP
Those doubting the growth-dampening
signal of the inverted curve have been proved
wrong. The 4-quarter change of real GDP has
slowed from more than 4 percent at the start of
2004 to less than 2 percent this year, and we are
still looking for the bottom.
4-Quarter Percent Change
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
Yesterday’s 50 basis point cut was a big
step in the right direction, but the Fed is still
imposing a Wicksellian penalty on the economy:
the real target rate remains higher than the
economy’s natural rate.
0.5
0.0
04.Q1
04.Q3
05.Q1
05.Q3
06.Q1
06.Q3
07.Q1
Fed Penalty
Real Fed Funds Rate less 10-Yr TIP Yield
100
50
0
-50
-100
-150
-200
-250
-300
-350
-400
1/4/02
1/3/03
1/2/04
12/31/04
12/30/05
12/29/06
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The Fed’s real target rate, the Wicksellian rate, is the target rate less the 10-year TIP
inflation spread, the inflation expectations
Real Fed Funds Rate
proxy. On Monday, with the 5.25 percent
target rate, the Wicksellian rate was 2.97
percent. Today, with the 4.75 percent
target rate, it has decreased to 2.43
percent.
Fed funds less 10-Yr Index-Linked Inflation Spread
3.2
3.0
2.8
2.97
2.6
2.43
The proxy for the economy’s
natural rate is the 10-year TIP yield. On
Monday, the Fed was imposing a 78 basis
point monetary penalty on the economy.
Today, the penalty has dropped to 21 basis
points.
2.4
2.2
2.0
Fed funds @ 5.25%
Fed funds @ 4.75%
Fed Penalty
Real Fed funds less 10-Yr TIP Yield
90
80
78
As economic growth has slowed,
the 10-year TIP yield has dropped
significantly.
70
60
50
40
30
21
20
10
0
Fed funds @ 5.25%
Fed funds @ 4.75%
10-Year TIP Yield
2.9
2.8
2.7
2.6
2.5
2.4
2.3
2.2
2.1
2.0
1/1/07
4/2/07
7/2/07
2
255
250
245
240
235
The Fed has room to cut rates without inflation concerns. The 10-year TIP inflation
spread shows that inflation expectations
10-Year Index-Linked Inflation Spread
are quite benign. Even with a minor
uptick in recent days, the spread remains
solidly in a range dating back to early2004 and averaging 245 basis points. In
fact, the spread spent almost all of this
year in the bottom half of the range.
230
225
Actual
inflation
readings
corroborate the benign inflation story.
The latest data show overall and core
inflation slowing to about 2 percent.
220
215
1/1/07
4/2/07
7/2/07
CPI Inflation
12-Month Percent Change
The Fed cut will also help to reverse
the drainage of reserves. High-powered
money growth has been slowing for
several years. With the Fed cut acting like
a tax cut on money, liquidity demand will
increase;
so
high-powered
money
(liquidity supply) will need to keep up.
5.0
4.5
4.0
Overall
3.5
3.0
2.5
2.0
Core
1.5
1.0
0.5
0.0
Jan.03
Jan.04
Jan.05
Jan.06
Jan.07
Adjusted Monetary Base
4-Quarter Percent Change
12
10
8
6
4
2
0
01.Q1
02.Q1
03.Q1
04.Q1
05.Q1
06.Q1
07.Q1
IFS-A138287 Ed. 09/2007
Kudlow & Co. LLC
Lawrence Kudlow, CEO
1375 Kings Highway East
Suite 260
Fairfield, CT 06824
203-228-5050 (p) 203-228-5040 (f)
Susan Varga, COO
John Park, Economic Associate
Dan Holland, Research Associate
www.kudlow.com
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Kudlow & Co. LLC
Lawrence Kudlow, CEO
1375 Kings Highway East
Susan Varga, COO
Suite 260
John Park, Economic Associate
Fairfield, CT 06824
Dan Holland, Research Associate
203-228-5050 (p) 203-228-5040 (f)
Meghan Wilcox, Economic Assistant
Provided courtesy of American Skandia Life Assurance Corporation a Prudential Financial company located at One Corporate
Drive, Shelton, CT 06484.
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