The Fed's Deflation Concern
Jude Wanniski
May 8, 2003


Six years late, the Federal Reserve’s Open Market Committee has spied deflation, not exactly upon us, but in the wings. Its statement Tuesday was that over the next few quarters “the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.” You can hear the gnashing of teeth when you read “fall in inflation” instead of “deflation,” and when the probability of that happening is both “substantial” and “minor.” Better late than never, the Fed is grappling with the issue at a time when the dollar price of gold – at what we consider its optimum range of between $340 and $360 – is signaling neither inflation or deflation ahead. The six years of deflation we have been alone in writing about since early 1997 have done immense damage to the world economy and the adjustments to that damage are still with us. If the Fed can open up this discussion in a way that leads to a constructive change in its operating mechanism, though, it could avoid what could be an “unwelcome substantial” new deflationary impulse in the next few quarters. It is much less important that the statement advised the financial markets of zero chance the Fed will soon RAISE the fed funds rate from the current 1.25%, as under its current procedures it would have to see inflation just over the horizon to do that. 

The problem remains that without the automaticity of a gold standard – which requires the Fed to supply exactly the amount of liquidity the market requires from day-to-day – it will repeat the error that got the deflation underway in 1997. Back then it was the cut in the capgains tax to 20% from 28% that invited a fresh flood of capital and the bigger economy. When the system asked for more liquidity and the Fed ignored the request, still fighting the previous inflation, dollars became scarcer than gold and the gold price began its long decline from the $385 level to as low as $250 in 1999. In the last year, gold traveled from $320 to $385 as the market developed a surplus of liquidity that the Fed had no way to drain. Higher risks associated with Iraq and the continuing adjustments to the deflation in those sectors still downsizing produced the run-up in gold. To get a good picture of the longer term swings go to the 10-year gold chart at, which clearly shows the gold trough. 

We now associate the decline to the current $346 level with progress of the new tax legislation on Capitol Hill. Of course, if the final legislation does contain the potent supply-side elements that are in the House bill that will be voted tomorrow (and if there are no surprises on the terrorist front), the system will ask the Fed for more liquidity. And because the Fed cannot supply it without changing its operating mechanism to target at least a basket of commodities that includes gold, the gold price will drag the rest of the price structure into a new deflationary cycle. It is always risky to read the mind of Fed Chairman Alan Greenspan, but he knows from experience that cutting tax rates on capital will produce the monetary deflation that bashed the world economy in the last cycle.  It was in January 1997 that I urged him to prepare the Clinton White House and his fellow Fed governors for the adverse effects of a declining gold price. You cannot change the operating mechanism without such discussion, even if it is behind the scenes.

Greenspan did open that door in his New York Economic Club speech on gold several months ago, so at least the stage is set. The problem has always been that other supply-siders have had an asymmetric view of inflation and deflation: Inflation begins when the gold price rises, with other prices following in train; deflation occurs not when the dollar/gold price rises, but when the Consumer Price Index is negative. It was because Robert Mundell, our supply-side Nobel Laureate in 1999, would not budge from this view that the Wall Street Journal rejected the deflation analysis which I argued – having first encountered in the 1982 when the Reagan tax cuts produced the steep decline in the gold price, to $300 from $625. In the May 12 issue of Fortune, there is an account of how the supply-siders are back in the saddle in the Bush administration and the GOP, “Here We Go Again.” The article is correct in that there is broad support for reducing the tax rates on capital in the Republican Party. But in reviewing the “failed” supply-side policies of Ronald Reagan and his tax cuts which produced only deficits, there is zero mention of how at first the deflationary drag overwhelmed the positives of the lower tax rates on capital and labor. It was not until Fed Chairman Paul Volcker was forced to abandon the operating mechanism set up to accommodate Milton Friedman’s money-supply fixation that liquidity could be injected to end the deflation and kick off the bull market. We can only hope that this time around Greenspan has a game plan to shift to a commodity standard if a declining gold price signals deflation ahead. 

There is today nothing new to report on the tax legislation, although the New York Times today notes the great enthusiasm by House Republicans for the substitute package designed by House Ways and Means Chairman Bill Thomas. That’s because it contains a cut in the capital-gains tax, to 15% from 20%, which makes it much easier to sell as a growth package than the President’s plan to eliminate the double-tax on dividends. If the White House would simply advise Senate Finance Chairman Chuck Grassley that it is okay with the House package, there would be more pressure on some of the Senate Democrats to break ranks and vote for the plan. With the 5-15 structure for both capgains and dividends, the Thomas plan would in fact pack more immediate punch and cost less than the White House plan. 

According to Bob Novak, the Democrats are already worried the polls show if the voting was held today they would lose five seats they now hold and only pick up one held by the GOP. Their Herbert Hoover- posture on the deficits with 10 million Americans unemployed could produce the equivalent of 1936, when Roosevelt won a second term in a landslide and Democrats won stupefying majorities in both House and Senate. The solid ranks of the Senate Democrats on tax cuts would hold up unless Republicans in both houses and in the White House get solidly behind the Thomas 5-15 package and refuse to accept its further watering down. South Carolina’s freshman Republican Lindsey Graham now has the rest of the party pointing out that $550 billion over ten years is only pennies of the $25 trillion in federal taxes that will be collected over that period. None of the Republicans are yet pointing out that if the 5-15 package passes, revenues will not only flow into federal coffers, but into state, county and municipal coffers of all 50 states. 

If they did, New York City Mayor Mike Bloomberg, who is now smothering the Big Apple with nuisance taxes to cut into its mammoth budget deficit, might get behind the tax cuts. The Bloomberg financial network he founded then might be connecting the fortunes of the major equity indices with the ups and downs of the tax legislation instead of attributing the big swings to earnings reports that only coincide with the swings now and then. It has only been when the Federal government slashes swollen tax rates on capital and labor that local governments suddenly find themselves flush with revenues. And the one place that always gets the biggest gushers is the nation’s financial capital, New York City. (Please somebody explain that to Mayor Bloomberg.)

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