I spent much of Monday and Tuesday in Washington with one objective in mind: Making the case that the Federal Reserve is going in the wrong direction in its measured quest for exactly the right federal funds rate. I met with key people at the Fed, in the Bush administration, and with economic journalists of some of the major newspapers, presenting my arguments and taking questions. My hope was simply to get top people in this loop to rethink the Fed’s “experiment” in searching for exactly the overnight bank lending rate that would optimize inflation and employment. And I did remind everyone I met with that since Fed Chairman Alan Greenspan embarked on this course last spring, he himself has made it clear that unlike all other attempts at managing monetary policy in the last three decades, this one has been a trial-and-error process. It is for example without the kind of theoretical backing, however flawed, that characterized the Fed’s attempt to manage the monetary aggregates in the 1979-82 period. This is critical because it makes it much easier for the Fed to re-examine the basic assumption of the experiment, which is that a gradually higher funds rate will choke off inflationary impulses in the economy without curtailing economic growth.
In each presentation, most lasting more than an hour, I pointed a finger forward to indicate the direction of the Fed’s search and then pointed it over my back, to suggest that it had already found the optimum rate when it was 1% and that it has been moving in the wrong direction, one that is steadily building inflationary pressures into the economy. My primary evidence, of course, was the steady rise in the price of gold since the experiment began, coupled with the decline in the value of the dollar against those major currencies that are not pegged to the dollar. In each case I dismissed the prevalent idea that the budget and current account deficits had suddenly caused the weak dollar. The correlation is more easily explained by the four interest-rate hikes since June 30, with the promise of more to come, with even some supply-siders arguing the funds rate may have to go to 4.25% by the end of 2005 to comport with their idea of a “natural” rate.
If there are 135 million workers and 40 million enterprises, from a shoe-shine parlor to Bill Gates, you must expect that when they are repeatedly told the objective of monetary policy is to reduce inflation by higher interest rates they will lower their expectations of growth to some degree. A smaller economy will need a smaller money stock, less liquidity, and this shows up immediately in the rise of the gold price. If gold’s equilibrium price is closer to $350/oz than to $455, which it was during my presentations, the $105 gap suggests that the inflation rate over the next 10 years will average 2.65% annually. This is also roughly what the ten-year TIPS/Treasury spread shows. Last year when gold was below $400, the TIPS spread indicated an average annual inflation rate of 1.5-2% over the next decade.
My argument was that if this incipient inflation is to be pre-emptively removed before it forces its way into the economy’s price structure, the objective of Fed policy has to be to get the gold price back at least to $400/oz. If Greenspan were to conclude that the current experiment would only make matters worse if funds are pushed higher and higher, he could -- with the support of the administration and other Fed members -- indicate he believes the dollar/gold price of $400/oz would accomplish this. It would be much easier for him to do this than to suddenly propose a cut in the funds rate, when the markets are now expecting an increase at next week’s FOMC meeting.
I suggested that if Greenspan did so, the market would quickly take gold down on its own, and the Fed would find the demand for liquidity so high that it would have to add money to keep gold from going below $400. The euro, I suggested, would immediately come back below 1.20 dollars per euro and the yen would come back above 110 per dollar. There would be positive effects in stocks and bonds around the world, the only “losers” being those speculating against the dollar or being long gold.
With the dollar fixed to gold at $400 and not to the funds rate, the funds rate would again “float,” and with the incipient inflation snuffed out we would expect it to decline, perhaps to 1.5%. To get back to 1%, gold might have to get back to the $350 level. The bullishness in the stock market is to some degree the result of the lower tax structure on capital formation now being accompanied by the incipient inflation instead of being offset by monetary deflation. Ending the incipient inflation with $400 gold, out of deflationary danger, would replace nominal increases in equity prices with real increases. When gold was at $35 oz in 1966 and the DJIA was at 1000, the increase in gold to $350 would imply a 10,000 DJIA. With gold at $455, the DJIA would have to be 13,000 to reflect real values. At its present 10,500, it is still well behind the capital efficiency we had in 1966, which is why it now takes so many more people at work to produce a comparable standard of living.
In each presentation, I also made the case that oil went as high as it has in dollar terms because the floating dollar forces all enterprises to manage affairs with “just in time” inventories. There were no energy shortages prior to the 1971 float of the dollar because the energy industry kept a 10% surplus against demand. Investment in energy infrastructure is so expensive that a miscalculation on the nominal price of oil can wipe out all higher-cost producers, which is why there is now not much more than a 1% buffer. If the industry knew the oil price would be roughly the same over the next several years, which it could do when the dollar/gold price was fixed, they would soon have the 10% surplus on hand for rainy days or wars in the Middle East.
Because I did not go to Washington to learn anything I can’t get by phone or e-mail, I did not ask any policy questions. In the several hours of meetings, I answered a hundred questions relating to past history, cause and effect, and the importance of gold relative to other possible commodity combinations. I also made it clear there was no impending crisis, but there would be if nothing changed and the Fed tried to “get ahead of the curve” by accelerating its quest in the wrong direction. If the funds rate were at 4.25% a year from now, I’d expect gold to be closer to $600 oz, the dollar much weaker, the cost of capital choking off corporate earnings, and the stock market back below 10,000.
What kind of overall assessment can I give you of this quick trip to Washington? My guess is that it had its intended effect. I’m almost sure the case I made will soon be discussed in wider policy circles, as in each case I was assured they would be. The $16 decline in the gold price today, with concomitant rallies in the dollar, undoubtedly got their attention. They can now certainly see more clearly the perspective I brought, that the Fed’s actions are causing the movements in gold, which then translate into movements of the dollar against foreign exchange, and not the other way around. The gold decline does mean an increase in the dollar demand for liquidity relative to supply and is a good thing in this circumstance. The decline in the dollar oil price in recent weeks in itself would be enough to explain gold falling as the U.S. business world cheers up on that account.
In one presentation, which went on for more than 90 minutes, I also got to make may argument that fixing the dollar to gold at $400 oz would have a great impact in reducing the current account deficit that everyone frets about. This is because the poorest countries of the world – commodity producers -- benefit most from a fixed dollar. The floating dollar since 1971 has had them in unending boom and bust cycles. If they could grow more rapidly, they would be importers of capital, which the U.S. would supply. In other words, by the U.S. growing “better” in real terms, but the rest of the world growing even better than we are, the current account would steadily shrink.
In each case I was pleased that there were requests for material I’ve written this year and most recently in further support of my case. And they all agreed to discuss these issues with me by telephone and e-mail in the period ahead, as long as I do not mention their names in my client correspondence. We’ll see what happens now.