March 30, 2004, 9:37 a.m.
Fed: No Speed Limits on Growth
A little light was recently shed on central-bank policy.

Fed Governor Donald Kohn recently gave a very important speech where he outlined the conditions that would spark rate-hiking moves by the Federal Reserve. It was really the most specific set of reference points mentioned by any Fed official to date, and a needed affirmation that the central bank has no near-term intention of feathering the brakes on this economic recovery.

Before jumping in, however, a little background on Donald Kohn: He may well be first among equals after Sir Alan on the Fed board. Indeed, as the former top Fed staffer and now governor, Kohn is in some sense Greenspan's right-hand man. So, when Kohn speaks, everyone should listen.

Mr. Kohn told the Washington Economic Policy Conference that the Fed is not likely to raise its target rate until demand picks up, productivity gains slow, and inflation risks rise. He specifically singled out unit labor costs (productivity-adjusted wage rates), saying they should begin to move higher before any Fed applies any restraint on the economy.

This is an interesting wrinkle in the Fed's Phillips-curve tradeoff between unemployment (or payroll employment) and inflation. The wrinkle is unit labor-cost growth, which has declined from 5 percent in the third quarter of 2000 to nearly minus-1 ¾ percent in the fourth quarter of 2003. This suggests there will be no interest-rate hikes for quite some time.

Kohn also mentioned that if productivity gains continue, then the economy's potential to grow will be far above current increases in demand, thereby reducing the need for companies to hire more workers. If that's the case, household spending will stall from slow job growth and there will be no need for rates to rise.

Kohn has an important point here. If the economy produces faster than it consumes, or if aggregate supply (investment) rises faster than aggregate demand (consumption), then overall prices will fall rather than rise. Hence, no Fed snugging.

Over the past three quarters of the real post-tax-cut recovery, inflation-adjusted economic growth has averaged 5.1 percent at an annual rate. Inside the economy, consumer spending (demand) has increased at a 4.5 percent average annual pace, while housing and business investment (supply) has advanced at a much faster 10.6 percent yearly rate. Business investment in equipment, software, and structures (i.e., office buildings and factory plants) has increased 10.2 percent. Therefore, supply is in fact growing faster than demand, a non-inflationary development.

The good news in Mr. Kohn's paradigm is that rising productivity — which is driving up profits, business spending, and overall economic growth — will not be countered by Fed action (as it was, disastrously, in 2000). In other words, at the present time there are no speed limits on growth.

The bad news, however, is that Kohn does not seem to believe that excess liquidity created by the Federal Reserve is the real cause of rising inflation, which means he is not paying attention to the big commodity rally or the recent rebound in gold, which has climbed back to $420. These raw-material and precious-metal gains are being driven in part by industrial demands from China, India, and the U.S. recovery.

But there is an important monetary dimension to the commodity rally — especially gold. Classical economic thinking stresses that recurring inflation increases are a monetary problem, not an employment problem (or a budget-deficit problem). Mr. Kohn seems not to agree.

Yet surely the Fed's money-adding over the past two years has played a considerable role in driving gold prices higher. Economic history teaches that a sustained gold rise can be a forward-looking market signal that money is overly plentiful and future inflation may well be more rapid than current inflation. That is a warning the Fed must carefully monitor.

All that aside, Kohn's comments are still most welcome. The Fed should make a habit of shining the light on its policy-making apparatus. And there's also a key message here that growth does not cause inflation. Amen.

— Larry Kudlow, NRO's Economics Editor, is CEO of Kudlow & Co. and host with Jim Cramer of CNBC's Kudlow & Cramer.