On the supply side - the failure of Federal Reserve Board policy to control money supply and maintain price stability

National Review, May 2, 1994 by Lawrence A. Kudlow

SUDDENLY it all changed. What was supposed to happen in early 1994--a continuation of the powerful bull market--didn't happen. Instead came a vicious bear charge, where famous hedge-fund managers lost hundreds of millions of dollars in currencies, government bonds, mortgage-backed securities, and stocks, while small investors bailed out of mutual funds. Consensus optimism turned negative overnight.

Perhaps the most immediate cause of the wobbly stock market is the collapse of bonds. A year ago the Clinton Administration, led by former Wall Streeter Robert Rubin, hailed the decline in bond yields as proof that world credit markets heartily approved of their record tax increase. They have suffered considerable embarrassment from the fixed-income rout (Treasury yields since last October have skyrocketed from 5 3/4 per cent to 7 1/4 per cent, a price loss of 17 per cent). Not only is the policy being discredited, but the analytical link between (lower 1994) deficits and (higher 1994) interest rates has again broken down.

Interest rates, especially longer-term rates, are primarily a function of future inflation expectations, not deficits. Rising inflation is always the bane of financial assets such as stocks and bonds, since investors worry that future repayment of interest and principal will be made with devalued dollars. Fearing this, investors reshuffle portfolios into commodity assets such as gold, real estate, raw materials, or durable goods that better protect their value against higher inflation. Since last autumn, inflation-sensitive price indicators such as gold and broad commodity indexes have increased by roughly 12 to 15 per cent, while yearly price changes in durable goods have jumped too--used cars by 7 per cent and existing homes by nearly 5 per cent.

Meanwhile, for all the talk of Fed tightening, the Fed continues to pump high-powered reserve money into the banking system. Over the past three months, adjusted Federal Reserve credit has grown at a 16 per cent annual rate. As a result, the market is losing confidence in the Federal Reserve and its stated policy goal of long-term price stability. The demand for cash balances, illustrated by changes in the narrow Ml aggregate, has grown by only 5.4 per cent over the past three months. Whenever the Fed supplies more cash balances than the market demands, the gold price rises and financial prices decline as investors move to hedge against inflation. This of course played out in the recent sell-off in stocks and bonds.

Since the surprise meeting a month ago between President Clinton and Fed Chairman Greenspan, senior Fed advisors have been telling people in private that the Board has no stomach for additional tightening in the near term, since any additional market turbulence will be publicly blamed on it. Unfortunately, the collapse of the bond market already indicates a loss of confidence in the Fed's strategy of gradualism. What's more, the expected appointment to the Federal Reserve Board of Alan Blinder, a confirmed liberal Keynesian unimpressed with the inflation threat, will further undermine market confidence and may well doom Chairman Greenspan's intention of pre-empting future inflation.

Outside the policy corridors of Washington, many Main Street shopkeepers wouldn't mind a whiff of inflation. After all, they have not been able to raise prices for nearly six years. And retirees might not mind higher interest rates on their saving deposits. It may well be that the political constituency for zero inflation is at a low ebb. That is why this is a dangerous period. The Fed must provide independent leadership right now. Otherwise inflation will really take hold, and once this process begins, it is very difficult to throttle back.

On another front, the financial markets are fighting higher taxes as well as easy money. It is no coincidence that the first major downward correction in market prices in three years occurred during the run-up to the April 15 tax-payment date, as people began to concentrate the collective mind on the largest income-tax increase in post-World War II peacetime history. The 1993 tax bill raised the top marginal tax rate from 31 per cent to 40 per cent, thereby reducing the aftertax return on the extra dollar earned from 69 cents to 60 cents. Additionally, three new entitlement proposals--for expanded Medicare, welfare reform, and job training--all of which will require still higher taxes, were announced in March.

What does this mean for investors? The after-tax yield on a 7.25 per cent government bond slips from 5 per cent to 4.35 per cent, while the after-tax return on the current 2.9 per cent earnings yield on the S&P 500 stock index drops from 2 per cent to 1.74 per cent. For six- and seven-figure investments, this represents sizable after-tax losses even if prices were unchanged. Prices, however, do not remain constant, as investors demand higher pre-tax yields and thus lower prices to compensate for the tax penalty.

Furthermore, while income-tax rates were raised in 1990 and 1993, Congress failed to index the capital-gains tax to offset the effects of rising inflation. Investors must therefore continue to pay taxes on the inflation element of any capital gain, as well as the real portion, and so any increase in inflation will sharply raise the effective tax rate on real capital and wealth.