The Fed Is Almost Irrelevant
Jude Wanniski
June 25, 2003


The nation’s central bank could of course do a great deal of good or a great deal of bad by changing its operating mechanism. If it targets gold it would eliminate monetary risk and if it tries to raise the consumer price index to prevent “deflation,” it would increase monetary risk. As long as it is still stuck with a mechanism that has the whole world trying to guess whether it will cut the federal funds rate tomorrow by 25 basis points or 50, it can do little harm or little good. Probably the best commentary I’ve seen in the public prints on this was Brian Wesbury’s op-ed in Monday’s Wall Street Journal, “Just Say No to Rate Cuts.” His argument against any cut is that it would not inspire any entrepreneurial risk-taking, and that at some point when the Fed has to go in the other direction, the rate hikes will cause economic damage.

The best thing about the Fed being irrelevant is that it has demonstrated it cannot manage the national economy by tweaking the rate at which banks borrow from each other at the close of business each day to meet their reserve requirements. After 12 cuts in 30 months or so, to 1.25% from 6.5%, the national economy is still in worse shape than it was when the cutting began. It was the ineffectiveness of targeting the funds rate when the problem was monetary deflation that led the White House and Congress to take actions that made matters worse. The future looks better because the President rammed through Congress a decent change in the way capital formation is taxed, but the economy still is not “poised for barn-burner growth,” as Wesbury wrote in the WSJ.  Please notice the steady slide in the dollar/gold price as the markets sense less of a threat to the system from a “bad change” in the Fed’s operating mechanism. As the superior tax climate continues to feed into business confidence and the stock market, there is now much less chance the Fed will ignore the funds rate and try to lift the CPI. I’m told Larry Kudlow is today arguing the Fed should print money until the price of gold is up 10% or 20%, as insurance against deflation.

That would have worked back when gold was still in deflationary territory last year, and it may be worth looking at if gold continues its slide back in that direction. The health of the economy always improves when the gold price is rising toward its optimum level or is falling toward its optimum level. If $350 is the optimum level, as we still believe, any action or inaction by the Fed that causes this dollar/gold exchange rate to fluctuate increases the risk of doing business and subtracts from capital formation. At the optimum rate, where the interests of debtors and creditors are in balance, any move tilts the equilibrium with losses to the overall system. What we have to watch now is the effect the new tax structure has on the demand for liquidity. As marginal producers creep back into the system, they do need fewer interest-bearing Treasury debt and more non-interest-bearing Fed liquidity, which they can convert into dollars for transaction purposes. If they do not get it, the dollar will become steadily more attractive than gold, which also pays no interest, and monetary deflation will resume.

The process is somewhat like watching grass grow, which is why we have cautioned that the bull market underway since mid-March will take time to develop further. It was in mid-March that Wall Street began to see the tax legislation in Congress begin to move from conception to birth. It looked ugly at first, but it was still alive, and at birth it turned out to be a pretty baby after all. Now as it grows, it will need liquidity or there will be health problems of the same kind that occurred when the supply-side tax cuts of 1997 began moving from conception to birth early in 1997. In March 2001, when I met with Treasury Secretary Paul O’Neill, I used a similar metaphor to describe the monetary deflation that could not be fixed with tax cuts or interest-rate cuts. It was like a skinny kid finally being fed and filling out, but being forced to climb into the same suit of clothes every day. It took awhile for the White House to shift gears on tax policy, changing the team that produced the first ugly effort. It is not too much to expect that it may shift gears on monetary policy in time to avoid the unhappy consequences that would show up on its doorstep just before the elections next year.

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