The Channel Economy The tax-cut tide versus the Fed's headwinds.

The following presents one good reason to read the Wall Street Journal. From their editorial page:

The Channel Economy The tax-cut tide versus the Fed's headwinds. Saturday, September 30, 2006 12:01 a.m. EDT

If you're unsure about the direction of the U.S. economy, don't worry. Most of the "experts" are too, including the gurus at the Federal Reserve. This is what happens at the stage of an expansion that a friend of ours compares to a shoreline river channel: The tide is going one way but the wind is going another, creating a significant amount of chop and turbulence.

The tide in this case is still coming in, with the economy continuing to show underlying strength. While growth in the second quarter was revised downward this week to 2.6% from 2.9%, the main reason was less inventory buildup. In other words, that growth reflected real demand. The third quarter that ends today has also shown few signs of the great slowdown that many of our most quoted commentators have been predicting for months, if not years.

The job market remains robust, with the unemployment rate at a low 4.7% and weekly jobless claims falling. The big story in many parts of the country has been a labor shortage, especially for skilled workers and where the crackdown on immigrants has reduced the labor supply. Employers are paying more to keep their best employees, which is why wages have begun to rise more rapidly--as they typically do at this stage of an expansion. Combined with falling gasoline prices, this will help buoy consumer spending in the months ahead.

Meanwhile, corporate profits and business investment keep growing at impressive rates. This has been the case since the 2003 tax cuts became law, raising the after-tax return on capital investment. The GOP Congress hasn't accomplished much this year, but one achievement was its extension of the 15% tax rate on capital gains and dividends for another two years through 2010. (Credit Arizona's Jon Kyl, who almost single-handedly pushed this through the Senate.) This maintains these incentives to invest past the 2008 election, when taxes will be a major battleground.

So what's creating today's choppy waters? The answer is that the economy is now adjusting to the Fed's mistake of keeping monetary policy too easy for too long from 2003 into 2005. The Fed did an admirable job of easing money in the wake of the dot-com collapse and 9/11. But spooked by what Ben Bernanke (then a Fed governor, now chairman) called "deflation," and underestimating the power of the 2003 tax cuts, the Fed let inflation creep back into investor expectations.

We are now living with the consequences of that mistake. A housing boom that in some markets became an asset bubble has begun to come back to Earth--painfully so for those who stretched the limits of creative financing. Many Americans measure their net worth largely by their home values, so the housing slump also makes them feel poorer. The good news is that prices rose so far so fast that they'd have to fall quite a ways before they reach the declines last seen in the early 1990s. The slump will, however, take a bite out of GDP for some time to come.

The other great adjustment is likely to come as commodity and natural resource prices adjust to tighter monetary policy. Some of our friends keep saying that the rise of gold, oil, iron ore and other commodity prices in recent years was merely a change in relative prices due to rising demand from China and elsewhere. But we've never seen such a rapid price rise that wasn't also rooted in renewed inflationary expectations. Gold only climbs above $700 an ounce from close to $400 in two years when the Fed is creating too many dollars.

Some of these prices are now falling, as the Fed sticks more diligently to its antiinflation mandate. A decline in oil prices will help the economy, but some investors who made big bets on natural resources will be casualties. Just ask Amaranth Advisors, the hedge fund that may have to liquidate after one of its masters of the universe lost $6 billion betting on energy prices. There will surely be other Amaranths, though a silver lining is that its collapse has so far caused barely a ripple in the larger financial system. A few rich people merely lost a lot of money; that's capitalism.

Today's choppy waters are teaching us once again how dangerous it is for the Fed to allow inflation to infiltrate into investment decisions. Capital begins to move based on anticipated price changes, not on underlying economic value or technological promise. The price and asset booms are great while they last, but the workouts are painful.

A useful thought experiment is to imagine how the last four years would have gone without the tax cuts of 2003 to help overcome today's monetary headwinds. Growth has averaged nearly 4% a year, federal revenues have increased by more than $500 billion over the last two fiscal years, and unemployment is low. If tighter money leads to more trouble in the months ahead, let's hope Washington has the wit to cut taxes again.