A Bit of Deflation Relief
Jude Wanniski
May 18, 2001

The delayed reaction of the markets to the Fedís half-point cut to 4% in the funds rate is the most promising news we have seen in months. As we noted in our brief yesterday afternoon, the market surge began in earnest when it was clear the Fedís open-market desk was having to add more liquidity than it had originally planned to push the rate to 4%. Even then, the series of $11 billion in repos between 9:30 and 10:30 a.m. still left funds trading at 4.125%, and another injection was necessary this morning as funds still were trading above target. When this happens, of course, the Fed is forced to put more liquidity into the banking system than the banks need or want, resulting in an increase in the price of gold -- up $4 yesterday and another $1 today, to the level we had at the first of the year. It is much better getting deflation relief in this form than it is by having the tax legislation watered down. Thatís how we assessed the earlier gold move to $268 from its trough of $256, when prospects for significant supply-side tax cuts were at their zenith, as the real economy would need more liquidity if it would see a more favorable tax horizon.

Weíre still not out of the woods, but this is a much nicer path on which to be. Every increase of $1 in the gold price means the universe of all other prices will not have to decline, on average, by the same percentage. It reminds us of the aphorism that it is easier for Mohammed to go to the mountain than for the mountain to come to Mohammed. When I met with Treasury Secretary OíNeill in March, I more or less responded in this way to a question about how high gold has to go to bring relief, saying I would not feel comfortable until we got to $300. It could get there most easily by having Fed Chairman Alan Greenspan actually say that he would feel more comfortable with gold over $300, but nobody ever asks him questions along lines that might elicit such an answer. Thatís why the 30-year bond has been behaving so poorly, we think, as the market must believe Greenspan now is more worried about rising unemployment than he is about deflation. The difference is critical to the market because the Federal Reserve should not be in the business of expanding or contracting the economy, but of preventing inflations and deflations. If Greenspan & Co. are on a Phillips Curve to trade more inflation for less unemployment, bonds are much riskier than they would be if the market would see that he was being influenced by a monetary price rule and were watching gold and commodities.

The difference could mean a full 100 bps on the long bond, the yield of which may be close to a peak. There are so many variables at work in these pricing moves that we remain cautious about timing, but the action in the funds rate and the gold market encourages us to think there could be more significant strides away from the deflation drag when the Fed Open Market Committee meets at the end of June. Market commentary seems to have decided there may be another quarter-point cut on funds, but a half point cut to 3Ĺ% more likely would reflect a greater degree of concern by Greenspan on the importance of price expectations. If Greenspan wants to avoid unemployment problems in manufacturing when the new auto models appear this fall, he has to be sure enterprises expect slightly rising prices if they are to build inventories. Auto prices fell by 2% in April, according to the latest CPI, as the industry stepped up incentives to clear out inventories. If it shows up with new models in September with sticker prices reflecting higher wages and pension costs, the third quarter will sag, unemployment will top 5%, and the Christmas quarter will be unhappy too. All that could be avoided if Greenspan not only does the right things, but says the right things too.