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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 1 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 3 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. 4