A 2005 Q & A Jude Wanniski January 4, 2005

Q. What do you make of the recent decline in the gold price? When it was above $450/oz last month you were thinking it could go to $500/oz, but it has since retreated and is under $430/oz.

A. The only consensus at Poly is that there has been an increase in demand for dollars at the turn of the year. The best "fit" with our model is the idea that U.S. multinationals that can now repatriate profits and pay a low corporate tax have waited for the new tax year to repatriate. They would have to liquidate assets and cash balances in foreign currencies and acquire dollars to bring home. You may recall Poly hoped the tax bill would pass early in 2004 to increase the demand for dollars, which might have persuaded the Fed that it could put off increases in the funds rate. The legislation was signed into law so late in the year, after the elections, that companies wishing to take advantage of the tax holiday had to first await details on how it would work. We`re considering some other possibilities relating to the Fed`s year-end shifting of reserve bank credit but will keep you informed as there is more clarification.

Q. Assume Polyconomics is correct in its analysis of Fed practices and the Fed does not change from its regimen of rate increases. What are the implications during the next 12-18 months for an equity asset manager? For a fixed income asset manager? And are there any further indications of the extent to which the Fed or the White House may be interested in or persuaded by the Polyconomics analysis of dollar weakness? Do you believe the Fed and the White House share a common goal of steadying and strengthening the dollar?

A. Last questions first: There is more interest in our thesis inside the Fed when gold is on the rise, but as it declines, strengthening the dollar <I>vis a vis</I> forex along the way, there is less interest in taking the focus off "measured" increases in the funds rate. Still, if the equity market retreats and there is weakness in the economic and employment numbers, our arguments should weigh in the balance in having the FOMC take a pass on one or more ff rate hikes this year, just to see what happens. They know they are experimenting, we think. Our sense is that reports the White House, Treasury and Fed are satisfied with a weaker dollar to resolve the current-account deficit are overblown. 

Equity managers have to remain sensitive to the possibility that gold will move lower with increases in demand for dollars and that this will take some of the nominal "froth" off equity prices. If the market begins to discount the possibility of meaningful tax reform, this alone could reverse gold`s inflationary trend. The equity markets have enjoyed the "easy money" ride and there would have to be a counter-reaction if increased money demand tightens the credit markets. NASDAQ stocks, which rose faster than the blue chips in the run-up, would fare worse in a run-down. As for fixed income managers, the 10-year and 30-year bonds should not move much from where they are unless gold resumes its upward march after this pause. 

Q. Do you expect the oil price to continue receding in 2005?

A. Everything else being equal, it should continue to drift lower. "Everything" was not equal last year when oil skyrocketed. Everything went wrong at once… insurgents in Iraq, hurricanes in the Gulf of Mexico, strikes in oilfields, Yukos. If the good news equals the bad news in 2005, oil should be a bit lower at the end of the year, as we still believe at $430 gold, oil should be at $30 bbl. It would not get that low again unless there were monetary reforms to take inflation/deflation out of the oil markets.

Q. If the dollar gold price continues moving higher, at what price (if any) would oil producers be expected to demand payment in euros or another currency?

A. Oil producers have the option of taking payment in stronger euros or weaker, but more, dollars per barrel. They won`t jump from the dollar as the invoice currency unless the Europeans come up with a fixed euro/gold price, and as long as the Fed can manage the dollar without igniting a new inflation the status quo will be good enough for OPEC.

Q. You`re bullish on a continued up trend in commodities prices. You`ve noted several times that the U.S. economy is in the early stage of an incipient inflation, and imply it will be protracted. Just how long of an inflation era are you projecting? A decade or longer?

A. We`ve also said repeatedly that even with gold 25% or 30% above its equilibrium value of $350 oz the implied inflation rate over the decade it would take to unfold would not average more than 3%. To get that implied inflation rate down to a more salubrious 1.5% would mean an increase in the demand for dollars that would take gold below $400/oz and keep it there. 

Q.  How much of the upward move in commodities prices that you`re expecting is due only to inflation? As the almost certain Fed funds rate raising continues, which they and you expect will moderate economic growth, won`t that in itself mean a price drag for commodities, (in addition to commodities supplies catching up with demand), thus resulting in lowered earnings for producers? Supply-Side Portfolio has the overall commodities sector among its best industry sectors.

A. Any increase in commodity prices not due to inflation is due to temporary shortages of supply relative to demand. These swings are always occurring, even in a gold standard, but with a floating dollar they are exacerbated. If the Fed continues raising the ff rate, this would of course tend to slow the economy, but with nothing else going on, the price of gold will climb again, causing nominal commodity prices to rise as well, a condition known as "stagflation." There are also positive forces working on the U.S. and world economy that fit into the commodity calculus, which is one of several reasons we have the sector near the top of SSP.

Q.  Recalling your famous March '01 "no reason to hold equities" advice to clients and your precise call last summer of a 4 1/4 10-year at '04's end, doesn`t your subsequent bearish comments on bonds and longer term inflationary expectations suggest a "no reason to hold or buy Treasuries?"

A. Not at all. Back when the 10-year was at 4.15% I said if I had a gun at my head I would predict the yield would go up, but not all that far to 4.25%. The yield then fell below 4% for a very short time before it moved back up. These are narrow ranges, and I become more bearish on bonds only when I see no positive forces helping maintain the demand for dollars. 

Q.  Arthur Laffer said in the WSJournal yesterday, "There have been times in the past when the dollar depreciation of the magnitude we`ve experienced over the last two-plus years would have been a clear harbinger of much higher inflation and interest rates. But such is not the case today. It is true that products which are freely traded in global markets will experience dollar price increases relative to foreign prices by the percentage depreciation of the dollar. But to have these exchange-rate induced price increases lead to higher U.S. inflation would require the Fed to accommodate the higher inflation with faster monetary-base growth. The Fed has not accommodated any higher inflation and as a result markets do not anticipate higher inflation. Nor should they." There seems to be a difference between you.

A. The difference goes back decades as I have not used Art' monetary model since we parted company in early 1981. He doesn`t really incorporate the demand for money into his reckoning, looking solely at the Fed`s balance sheet and money supply. He`s at least right on the magnitudes. There is nothing like the runaway inflation we had in the late 1960s and 1970s, when gold`s increase topped 1000%. Art has also been consistent in arguing that to squeeze inflation out of the system would require gold to go to $250 oz, yet here he is seeing no inflation at $430 oz. Note he never mentions gold in his op-ed.

Q. In your year-end geopolitical letter you made the statement: "The U.S. current-account deficit would fade because the rest of the world has more unrealized potential than we do, which means they would become net importers of capital and the U.S. would become a net exporter." Could you amplify?

A. This is standard supply-side doctrine, where Laffer and I will never disagree. The current-account deficit is the result of capital inflows, where the rest of the world prefers to hold dollar assets at the margin and must then sell us more than they buy from us in order to make up the difference with purchases of U.S. stocks, bonds and real property. If there is to be a capital outflow and a U.S. surplus on current account, either we do bad things to ourselves to slow the economy and discourage capital inflows, or we follow policies that will tend to make the world grow faster than we are growing, although both are on growth tracks. Fixing the dollar to gold provides the whole world with a stable unit of account, to which all countries can fix or at least follow as a guide. In many poor countries this stability would push growth rates well into positive terrain, even into double-digit growth. More U.S. capital would flow to them as U.S. investors snap up their stocks, bonds and real property.  As a matter of fact, back in 1980 I made the argument that even before a Reagan presidency cut tax rates it should consider refixing the dollar at an appropriate rate, as the tax cuts would mainly benefit the U.S. while the dollar`s stability would benefit the world. 

* * * * *