A Letter to Bernanke
Jude Wanniski
January 6, 2004


To: Fed Governor Ben Bernanke

Dear Ben:

I read your San Diego speech from end to end and at least was happy to see you mention the gold price, which you note was at $410 per ounce. That`s when the speech was written. I do think gold has run up to $427 in two days chiefly because of your speech and because of Greenspan`s Saturday speech, both of which took a very casual approach to all the signs of incipient inflation that abound. In combination, the two speeches nullified the slight tilt away from the Fed`s "deflation posture" that was announced after the last FOMC meeting when it said there was as much risk of inflation as of deflation. The only saving grace in Greenspan`s speech was his note that a "pre-emptive" attack on inflation might lower stock prices in the short term, but contribute to higher stock prices in the medium and long term. I`m afraid that if gold gets much higher, you will have to be much more aggressive in your pre-emptive increases in the funds rate to get ahead of it.

The dollar/gold price should be no higher than $350 per ounce, which is really where there is a balance on either side toward an incipient inflation and deflation. In order to keep the funds rate at 1%, you have to add more liquidity than the dollar economy needs or wants, which means that at the margin gold becomes scarce relative to paper. Your basic mistake is not only in looking over your shoulder at the monetary deflation that took place between December 1996 and April 2001 (when gold hit bottom at $255, as you yourself note), but also in your belief that a 10% increase in commodity prices only causes a 0.7% rise in consumer prices. A 10% rise in the dollar/gold price eventually must cause a 10% rise in the general price level, although it will take time for that adjustment to occur. If gold were permitted to stay at $427 -- let alone move higher -- there would have to be a 22% rise in the general price level, with commodities leading the way.

There are several factors causing a decreasing demand for fresh liquidity at the same time the Fed is supplying more than the market wants, which makes me fear an acceleration of the problem. If gold can jump $17 per ounce in two days, it can theoretically jump $170 in 20 days. We have alerted our clients all along the way to the actions taken by the government that cause the economic system to be hesitant in taking new risks. These are mostly due to new regulations imposed by the corporate governance scandals and by the Patriot Act. The Fed cannot do anything about these, but must take them into account when judging the appropriate amount of liquidity being added in order to sustain the 1% funds rate. If you did, I believe you would be getting funds more quickly above 3%, or gold will spike at a level that will force you to act belatedly rather than pre-emptively, to use Chairman Greenspan`s terms.

In your speech you also point to the rising demand for commodities in China as a reason for the rise in dollar/commodity prices. If this is true for the dollar/copper price or the dollar/zinc price, though, why is it that the euro/copper price and the euro/zinc price are not climbing? In this context, it must be clear to you that the problem is not in China, but in the inflationary posture of the Fed. And you are primarily the author of that policy, you must know, because you have been its intellectual champion during the past year.

A good part of the gap between your perspective and mine, I believe, is your view of the price of oil, which you believe remains a "disinflationary" force within the general price level. In one sense you are correct, in that the oil price is now higher at $33 than it would be in its traditional relationship with the dollar/gold price. That`s not primarily because of Iraq or OPEC rigging of oil, but because of the side effects of the 1997-2001 monetary deflation. Oil followed gold down to a point where investment in new oil infrastructure became impossible. When the world economy began growing again in 2002, there was no inventory of oil meet the fresh demand. If you do not take this into account, you will fail to appreciate the damage done to the U.S. and world economy by the absence of a gold-price target at the Fed in the years before you were appointed. In his San Diego speech Saturday, Greenspan glossed over these points because he was at the helm and prefers to not remember the warnings he had in 1997 about the damage already underway in the commodity producing countries, damage that caught up with the rest of the economy in 2000.

There is of course still time to get the incipient inflation under control, but I do think you are the "man on the margin," who should be the first to concede that there should be a policy shift sooner rather than later. If it is done sooner, it can be done gradually, and painlessly. If it is done later, it will be difficult and painful.

Sincerely, as ever,