Big Ben's Big Beginning
Fed Chairman Ben Bernanke is off to a good start

After two days of congressional hearings, new Federal Reserve Chairman Ben Bernanke delivered a “not-too-hot” and “not-too-cold” testimony that reassured financial markets – driving up share prices by roughly 1 percent across the board, while gold, bonds and the dollar held flat.

On the Bush side of the rally, the Senate has voted 53-47 in favor of extending the president’s investor tax cuts on dividends and capital gains. Joining in this breakthrough vote was Sen. John McCain,who voted against these tax cuts when they were introduced in 2003. This is an important shift for the GOP presidential frontrunner – and a big win for pro-growth fiscal policy.

Even better, it seems that Bush and Bernanke are on the same pro-growth side. During his hearings, Bernanke gave the Bush tax cuts credit for the economic recovery. He also pledged to keep basic inflation around 2 percent or less as he narrated a positive view of the economy.

Bernanke’s biggest concern on the inflation front seemed to be a spillover effect from higher energy prices. But with energy inventories high, lower prices will pull down inflation rates in the next couple of months. Indeed, lower gas prices at the pump are increasing the purchasing power of consumer incomes, which have risen with steadily impressive job gains. Any cooling of the home real-estate market and the “cash out” income from that market is being more than offset by the job creation of healthy American businesses, low unemployment and rising incomes. The reality is that the Bush tax-cut incentives continue to propel economic growth.

Just look at the outsized gains in retail sales, new home construction and manufacturing production. Then look at the flood of new tax collections from the strong economy that has thrown off unexpected federal budget surpluses over the last two months.

Bernanke impressed during his testimony when he referenced an important bond-market model of inflation expectation calculated from the difference between inflation-indexed bonds and cash bonds. These forward-looking bond-market indicators tell Bernanke that inflation worries are “well-anchored” and that the Fed’s interest rate target should stop at 4.75 percent or 5 percent, at most.

However, Bernanke was much less impressive when he made lingering references to resource utilization and “excess” economic growth above potential. Remember, in the second half of the 1990s, unemployment dropped to 3.9 percent, while real economic growth averaged above 4 percent – both of which occurred without upward inflation pressures. But the Fed worried about “irrational exuberance” and made the wrong policy call – it began aggressive over-tightening that led to a generalized deflation of commodity, equity and business investment. This was Alan Greenspan’s biggest mistake, predicated on a short-run Phillips curve trade-off that gave the central bank a very bad policy signal.

Hopefully, Bernanke will stick with the bond indicators, bolstered by commodity- and currency-market signs, and will push the Phillips curve into the background where it belongs. Otherwise, this old Soviet Gosplan approach to central planning will doom the recovery cycle.

Contrary to the advice of Keynesian government planners, low tax rates and a rising economy are the best means to domestic price stability and prosperity. Let’s hope Bernanke stays on the right side of this debate.


Lawrence Kudlow is CEO of Kudlow & Co., an economic and investment research firm in New York City
editorial@lanereport.com

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