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Warding off inflation with falling marginal rates and increasing productivity.

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Inflation Hawks Dead Wrong

Warding off inflation with falling marginal rates and increasing productivity.

A rising gold price and a falling dollar typically spell much higher future inflation and interest rates. So, with today’s gold price at an upward-trending $425 and the dollar continuing its decline, why doesn’t the monetary formula hold up?

Well, there are mitigating factors in this economic cycle that will subdue inflation and interest rates, neither of which will block a near 6% real economic growth rate and another 20% stock market gain this year.

Today’s high gold price and weak dollar do signal excess money in the system. However, that liquidity will be absorbed by the reduction in high marginal tax rates on personal income, dividends and capital gains; high productivity; and rapid economic growth.

In short, more money will be chasing even more goods and services. Hence inflation will be quiescent.

In fact, lower tax rates and higher productivity are reducing the entire cost structure of the economy even while they create new incentives for investment and capital formation. Rapid productivity gains reduce labor costs and increase real wages and real output. Lower taxes also reduce the cost side of the economy. Whatever one produces, lower taxes make it cheaper to do so.

Supply-siders sometimes forget that taxes are an important cost of living and doing business. But Uncle Sam’s reduced tax-take on investment lowers the after-tax cost of capital, and this is passed through as lower production costs. Lower taxes will in fact reduce consumer prices.

As for the dollar, a broad index of 30 currencies, adjusted for prices, has fallen only 13.5% from its excessive peak two years ago, and remains 15% higher than its prior low in 1995. From this perspective, today’s dollar panic is unwarranted.

In addition, European monetary policy is too tight, and new European Central Bank Governor Jean Claude Trichet is looking at an interest-rate cut to spur better growth of the EU’s moribund economy. This will stabilize the dollar against the euro.

At home, monetary trends are not flashing inflation signals. High-powered reserves created by the Federal Reserve, known as the monetary base, are growing around 5.5% yearly. The very basic money supply known as M1, which includes currency and demand deposits, is growing at 6%. This is a good balance between money supplied by the central bank and money demanded by the economy.

And broader money measures have actually been declining of late, as individuals liquidate savings accounts and money market funds in order to reinvest in the roaring stock market. For good reasons, money is being put to work in the market and is financing the expansion of business.

The rise in gold over the past couple of years from $255 to $425 does reflect mild monetary excess. But this was necessary to end deflationary price drops that were sinking profits and the economy.

The Fed’s 1% policy rate was deliberately set below the economy’s so-called natural-or real-interest rate of 2%. The consequence will be a slight rise in inflation (1/2 to 1%) over the next 18 to 24 months. But all that amounts to is a core consumer price index of slightly less than 2%.

Treasury bonds have already discounted the slight inflation rise caused by the Fed’s easy money. Last summer 10-year Treasury bonds jumped in yield from 3% to today’s 4.5%. That was a big move, but it did not break the back of the stock market or the economy. Future interest-rate increases will be minor, not major.

Through all this, we’ve witnessed excellent policy coordination between the Bush White House and the Federal Reserve Board: Last May, the president signed the best pro-growth tax cut in 20 years; immediately following, the Fed cut its policy rate by a quarter percent. In other words, monetary policy accommodated the shift to an expansionary supply-side tax cut that was directly and correctly aimed at curing the three-year-old bust of stock market and business investment.

In the 1970s, the economy suffered from inflationary recession. The supply-side cure was lower tax rates to ignite the economy and tighter money to curb inflation.

In recent years, the economy suffered from deflationary recession. The supply-side cure has been easy money to stop prices from falling and an across-the-board reduction of high marginal tax rates to ignite the economy.

Liberal Keynesian politicians and their academic advisors predicted inflation in the 1980s. They were dead wrong. Some of the very same voices are again predicting inflation now. They will be dead wrong again.

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Mr. Kudlow hosts CNBC's "Kudlow & Company" and is a nationally syndicated columnist.

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