A Letter to FOMC Jude Wanniski and Paul Hoffmeister January 10, 2005

In reading the minutes of recent meetings of the Federal Open Market Committee, we note a wide range of opinions among members and Fed staff on how to proceed in your quest for economic balance. It is encouraging to see you and your colleagues observe the need for concluding excessive monetary accommodation. But we remain concerned that your prescription – raising the overnight federal funds rate at a measured pace -- is an imperfect tool, one that cannot achieve balanced growth in the supply and demand for liquidity. If our analysis is correct, you will be frustrated in your efforts to contain inflationary forces and may even add to them. 

Even with five quarter-point increases in the funds rate since June 30, you face the current predicament of an increasing money supply while money demand remains in decline. FOMC minutes indicate liquidity demand is in no way being addressed by funds rate targeting while its decline is exacerbated by persistent concerns in the markets over the inflation and economic outlook.  At the same time, money supply is increasing contrary to the stated intent of the FOMC because expectations of a prolonged rate-hiking campaign encourage private parties to secure credit commitments from banking intermediaries in advance of future increases.

Current real-time market indicators in the bond, foreign-exchange, and commodity markets are signaling inflationary pressures rising within the U.S. economy.  Inflation-protected 5 & 10-year Treasuries are compensating lenders roughly 2.5% over their respective nominally denominated debt.  The dollar has depreciated nearly 20% relative to the 10-year moving average of the euro. Yet the spot gold price of $420 compared to its 10-year moving average of $330 is implying an average annual inflation of 2.4% over the next 10 years. We are surprised to see no mention of gold`s information signals in FOMC deliberations although it is the only commodity that reflects pure disconnects in the supply and demand for liquidity. It is the only commodity that does not "backwardize," i.e., its future price is never lower than its spot price.  

Recent history suggests that manipulation of the funds rate relative to the long-end of the yield curve will not effectively control this apparent monetary over-accommodation.  The Federal Reserve is fighting against a phenomenon noted during a similar period in the 1970s by the late Fed Governor Henry Wallich.  Funds rate targeting puts the Federal Reserve at the mercy of the banking system`s demand for reserves.  Fed targeting of the demand for funds by depository institutions is entirely different from controlling the total market demand for dollar liquidity. By buying and selling bonds until the effective funds target is reached, the Fed is targeting the price of credit and not the purchasing power of money. If private borrowers expect higher rates in the future, they will bid for more credit commitments from banking intermediaries before rates rise, forcing the Fed to monetize debt that adds liquidity to the system.  Conversely, if banks expect lower rates, bidding activity will slow in anticipation of these lower future rates, forcing the Fed to retrieve liquidity in order to hold the funds rate target. 

This "treadmill effect" suggests that firming expectations of future rate increases force the central bank to add liquidity to reach its credit price target, counter to its intention to subtract liquidity from the system.  This phenomenon should not surprise you as it was at least discussed during your November 10 meeting.  According to the minutes, the Manager of the Open Market Account cited this concern.

The Manager discussed the pressures on the federal funds rate prior to, and volatility in the rate that has ensued at times after, recent FOMC meetings as depository institutions sought to satisfy a larger portion of their reserve requirements before anticipated increases in the FOMC`s target funds rate. The Committee agreed that the Desk would continue to conduct open market operations as it has in such situations--leaning against anticipatory pressures in the funds market while taking account of the reserve management implications of such operations for the remainder of the reserve maintenance period.

Reserve bank credit data, essentially the asset side of the Fed`s balance sheet, indicate that the  "treadmill effect" has been occurring since spring 2004. In earlier experiences of this kind, we have likened the effect to what we would expect if the government were to announce a series of tax increases on a gallon of gasoline. Motorists would "top up" their tanks in advance of the hikes, just as they would tend to run low if they knew the price would drop on a certain date. 

Market indicators of rate hike expectations moved significantly higher during March and April, signifying a consensus among financial actors of a protracted rate hiking campaign.  This change in market expectations caused an increase in reserve bank credit growth since May as depository institutions sought to satisfy reserve requirements before additional quarter-point rate increases, despite Fed pronouncements of a "tightening" bias.  

Furthermore, and equally important, the strategy of targeting the extent of monetary accommodation via the funds rate implicitly ignores the demand for money -- which is always changing. People will hold less non-interest bearing debt during inflations because stagnant money continually loses value. During deflations, as the purchasing power of cash increases even while stagnant, people are willing to hold more of it.  

Money demand is also influenced by economic growth prospects. Individuals and enterprises will maintain more readily available money as financial transactions increase. A useful proxy for money demand is MZM data -- money of zero-maturity -- because it reasonably represents consumer holdings of non-interest bearing debt based on inflation and spending expectations.  MZM data indicates that the last three inflationary episodes in 1987, 1993 and today have coincided with a consistent erosion in the demand for the dollar. Most recently, MZM growth peaked in December 2001 at a 21% year-over-year rate, and has steadily declined ever since to roughly 4% today. Yet a corresponding decline in money supply never occurred; reserve bank credit since that time has maintained a relatively narrow range of growth around 8% year-over-year.  The result has been an over-expansion in liquidity.  Unsurprisingly, gold reached a bottom in December 2001 at $275/oz., and currently trades over $420.  

The fundamental flaws in targeting the overnight federal funds rate are two-fold: 1) yield curve management ineffectively controls the supply of credit; and, 2) funds rate targeting ignores the equally important variable, money demand.  Only when the Federal Reserve can equalize the long-term growth in both the supply and demand for money will true price stability be achieved. 

This dilemma suggests that equilibrium between money supply and demand will mostly likely be achieved when an exogenous effect -- outside the scope of the Federal Reserve`s open market operations -- reverses the trajectory in either or both variables.  A temporary pause from rate hikes or the conveyance by the FOMC of a reduced likelihood of further rate hikes would cause depositories to reevaluate their interest rate expectations, thus relieving pressure on the overnight funds rate and allowing a steady deceleration in credit expansion. Another realistic external event would be a fiscally induced strengthening in money demand – either in the form of an improved economic outlook or in the form of a specifically legislated mandate that enhances the attractiveness of the U.S. dollar relative to foreign currency. The result of either scenario, respectively, would be a reversal in the growth rate of the supply/demand variables for money.  In 1981-82, an economic expansion anticipated by the phased-in tax cuts of 1981 sharply increased the demand for liquidity and, when it was not supplied, witnessed a sharp decline in the dollar price of gold. We observed the same phenomenon in 1997-2000, when the `97 tax cuts on capital spurred economic expansion and gold fell from a $385 plateau to as low as $255 in the summer of 2001.

In fact, a combination of this scenario transpired between December 2003 and May 2004, during which reserve bank credit expansion steadily declined from a 6.78% YoY rate to 4.05%, while MZM growth reversed a two-year trend by increasing from a 3.56% rate to 5.41%.  Credit slowed based on the banking system`s demand for reserves, while MZM increased due to the expanding economy and bright growth outlook.  Concurrently, market inflation signals moderated, such as gold, which hit its 2004 low of $375.  Unfortunately, the month of April marked the turning point in this virtuous trend.  Financial markets were forced to adjust to news of a Fed campaign that would induce an acceleration in credit expansion and would threaten to raise the price on short-term financing.

In very recent weeks, as the new year began, the dollar/gold price ran down quickly to the $420 level from a December high of $455. We attributed the decline to an increase in the demand for liquidity in the new tax year as enterprises with money balances abroad began the process of bringing them home to take advantage of lower corporate tax rates on repatriated profits. In other words, some of the "inflation" problem you have been addressing has been taken care of by this fiscal variable outside your control. 

The thrust of our analysis leads us to recommend that you consider using the information signal provided by the gold market in discussing your next moves at your upcoming meeting in February. Everything else being equal, a decision to signal to the market that rate hikes may not proceed as rapidly as the market now assumes to be the case should cause banks to allow their reserves to run down a bit, which would suggest a further decline in the dollar/gold price. By using information in the commodity market (gold) to stabilize the dollar at a rate consistent with low unemployment in the real economy, you would of course be replicating a gold-based monetary standard without giving up the freedom to move in other directions should you believe circumstances dictate such change.