Oil, Gold and the Fed Funds Rate
Jude Wanniski
March 18, 2005


With oil moving over $56 bbl and gold around $439 oz, the oil/gold ratio has moved below 8, getting near its lowest point in 20 years. In a fixed dollar/gold world, with the dollar better able to serve as a unit of account directing capital investment, the ratio was closer to 15. Why is that? Most gold reserves are above ground, in vaults, and most oil reserves are below ground, inaccessible without the infrastructure required to get them out, refined, and delivered to the consumer. In the absence of a gold standard, the dollar prices of these two key commodities are largely determined by the Federal Reserve, which is why it is useful to hang on every word of the voting members of the Fed. Its open-market committee meets again next week to contemplate the economic conditions around it, with speculation now intensifying on whether it will change a word or move a comma.

Based on our conviction that the Fed's policy of raising the funds rate is in itself inflationary, our biggest worry in recent months has been that instead of recognizing the inflation it has been creating, it would see in the rising price indices a need to raise the funds rate more aggressively. This is what is now creeping into the public discussion. In this kind of debate, the fact that the gold price has been rising and the dollar weakening against major currencies since the Fed began raising rates is not enough to persuade policy advocates that the policy is in error. They merely insist that the Fed should have been raising rates faster than it has since June 30, when it began, and that now it will be forced to make up for that error by raising rates by a half point at each FOMC meeting instead of only a quarter point.

This was the position taken Thursday afternoon on Bloomberg radio by David Malpass of Bear Stearns, among the most important Wall Street advocates of higher interest rates to combat inflation. He is important because he is a supply-sider with a following that includes the editors of the Wall Street Journal editorial page, the National Review, and CNBC`s Larry Kudlow. Malpass now says the funds rate must double by the end of the year and to get there the FOMC should be raising the ff rate by 50 basis points per meeting in the third quarter.

We`re not the only supply-side research firm that has been arguing against this Fed policy; Dave Ranson of H.C. Wainwright in Boston wrote a warning against the policy for Barron's last June 30 while I co-authored an op-ed with Jamie Galbraith, an old-fashioned Keynesian, for the June 29 Washington Times. Indeed, I`ve seen more support for our arguments from Keynesians, even though they don`t share our focus on the gold signal. Pimco's Paul McCulley, for example, this morning told CNBC`s Squawk Box that because the oil price is rising to such lofty levels, "acting as a tax" on consumers, the Fed should not be piling on by raising interest rates much higher. He`s happy at 2.5%.

It was encouraging to see Fed Governor Ben Bernanke on March 8 suggest that the "neutral" funds rate may now be lower than it had been in the past. I don`t know if we helped, but Bernanke is one of several Fed officials who has been receiving our research reports. He is a leading candidate to replace Chairman Alan Greenspan next year, along with Glenn Hubbard, the former chairman of the President`s Council of Economic Advisors. There is a general tone in the commentary we have noticed suggesting more restraint than Bear Stearns is calling for, perhaps related to the growing recognition that the higher rates seem to be related to the climbing oil price. Our Paul Hoffmeister notes it was on February 9 that the market, which had been sensing a "pause" by the Fed in its rate hikes, decided there would be no pause. Several measures that had been promising turned around at once: Oil at $45 bbl then, $56 today; the CRB Index at 280 then, 320 today; December fed funds futures at 3.41% then, 3.89% today; the 10-year note at 3.98% then, 4.49% today; gold at $413 then, $439 today. It was a few days later that Greenspan testified before Senate Banking, confirming the market`s earlier judgment that rates would be going higher with no pause. 

There are of course other things going on having an influence on the demand for dollar liquidity, all of which effect dollar prices and interest rates. While it`s very difficult to link up small movements in prices with political events, the gold price did come down $8 with some positive news from Capitol Hill on the budget. The best bit of news was the narrow defeat of the PayGo rule in the Senate, which would have made it much more difficult for the Republicans to extend the 2003 tax cuts on capital gains and dividends. After the Easter recess, we`re also hoping the President can get his Social Security reforms on track with at least a foot in the door on personal accounts. And Senator Shelby`s promise of hearings on Sarbanes-Oxley along with an SEC review should produce some favorable news that will push up dollar demand, and gold and oil down. Let`s hope.