Gold's Surge: When Does It Stop?
/The Fed and the Gold Move
Jude Wanniski and Michael Darda
February 5, 2002


The surge in the price of gold, now bumping against $300 from $275 just weeks ago, is not the result of the Federal Reserve trying to juice the economy along, but of a growing decline in the demand for dollar liquidity. There are several things going on at the same time, but if gold remains at this level because of the economic weakness the deflation wrought, there will be less deflationary pressure on nominal prices in the near term -- but at the cost of a longer recession. We have pointed out all along that the deflation could be ended either wisely by adjusting the dollar/gold price by a discrete devaluation, or unwisely by driving down the demand for liquidity and having the Fed fail to mop up the surplus. With an operating mechanism that targets overnight interest rates instead of commodities, the Fed now finds itself in the position of adding reserves in order to prevent the funds rate from rising above 1.75%.

The biggest change we have been following has been the condition of state budgets, which as of January 25 were facing an aggregate shortfall of $40 billion. Just in the last 10 days, reports are further darkening in many of the big states for fiscal 2002 and getting worse still for 2003. New Jersey estimated a $2.4 billion deficit for 2002 with no new tax increases contemplated. It now projects more than $6 billion in the coming year and the new governor, Jim McGreevey, who promised not to raise taxes, now indicates he only meant income- and sales-tax rates. Unless there is a quick end to the deflationary drag (which will remain until gold gets above $325 or so), the government revenue problems will escalate because state "rainy-day" funds will be exhausted. There are now 42 states facing deficits this year. By year`s end, it could be almost 50, while at the same time growing unemployment will force spending up. The news today is that President Bush is asking for a $500 million increase for Internal Revenue to crack down on tax cheats. This in itself is an increase in the "tax wedge," running up the cost of lawyers and accountants in most businesses and households where it matters. At the local level, watch your speedometer, as municipalities will be encouraging their cops to issue more tickets to bring in additional revenue. In our December 10 letter, "Gold and Bonds," we said there would be rallies in these assets for these kinds of reasons.

At the $300 gold level, we have to expect the nominal prices of commodities that already deflated to creep up to restore equilibrium, but prices of commodity companies that have not yet fully adjusted probably will not rally as much. Most commodity stocks already have anticipated higher commodity prices (based on expectations of economic recovery) and actually would fall if commodity prices did not rise. Regarding our projection of a year ago that the Dow Jones Industrials could hit 8500 by the end of this March (based on gold at $265), we actually still think the DJIA is heading for 8500. Gold is rising for "bad" reasons -- not because of a Fed policy change. Moreover, even at $300/oz., the economy will remain in a deflationary adjustment process. Most equity investors are expecting recovery and are pricing equities accordingly. As these expectations fail to materialize, equities should continue to creep downward.

There is still the remaining global political risks of a broadening war against the "Axis of Evil," but there is a growing sense the President is already softening that line of attack in his war on terrorism. Secretary of State Colin Powell may have given the Warriors at the Pentagon all the rope they needed to hang themselves and has played good soldier in support of the tough line. Meanwhile, Mr. Bush now is seeing that the rest of the world does not relish a broader war and will not join that coalition. It will be especially hard to move forward on that line as the Baghdad government has invited UN General Secretary Kofi Annan to hold unconditional meetings that could lead to the re-entry of UN inspectors into Iraq. Saddam Hussein never "kicked them out" in the first place in 1998. They left because he refused to take them to the weapons of mass destruction which they could not find but were sure must be hidden!!  If that is worked out, all that is left is a deal between Israel and the Palestinians, and that deal is much closer than folks are letting on.

Jude Wanniski

One of the ingredients for the gold move, we think, was the Fed`s decision NOT to cut interest rates again on January 30. The market no longer expects a falling funds rate in the near term but instead expects a flat-to-rising funds rate. This removes the perverse incentive to delay borrowing/lending activity into the future. Put differently, the price of credit now is expected to rise instead of fall, so there is an incentive to borrow now instead of later. This can place upward pressure on the inter-bank lending rate, which, ceteris paribus, would require the Fed to add more liquid reserves to the banking system in order to hold its interest-rate target in place.

The chart below tracks adjusted bank reserves -- the non-currency portion of the monetary base -- from January 2001. Adjusted reserves have expanded by more than 10% since early November, after the “emergency” 9/11 liquidity was removed. We would caution that this series is volatile, and could fall back in the coming months, especially if the pressure on the Fed`s overnight rate lets up. At this point, however, it is safe to say that there seems to be a confluence of factors that augur for a higher market-clearing gold price: the deterioration in state/local tax policy, heightened levels of worldwide political risk across currency areas, and a simultaneous rise in the Fed-controlled non-currency portion of the monetary base.

Michael T. Darda