Monetary and Fiscal Positives Jude Wanniski May 4, 2005

The Fed`s "bobble" of its FOMC statement yesterday afternoon, having to issue a correction after discovering it left out a key sentence on inflation remaining under control, conveyed more information than the statement itself. There are even blogs on the Internet grapevine suggesting the Fed planned the bobble, a most unlikely event in that the hour and forty minute delay in the correction cost some traders real money and would prove most embarrassing to the Fed as an institution. What it conveyed to the markets was exactly opposite of the initial, truncated statement that had sent equities south after some confusion. In the five minutes of trading remaining before the closing bell, the DJIA climbed 40 points. This was not only a marvelous display of the efficiency of the broad marketplace but also a definite Bronx cheer against further increases in the federal funds rate. 

We were of course gathered around our Bloomberg screens watching all the wiggles for confirmation on all counts of our thesis that the Fed`s experiment fighting inflation has been counter-productive. Sure enough, the 10-year note, immobile at 4.19% after the first release, fell to 4.16% in that same few minutes that moved equities higher. Also after the first release, the most sensitive measure of gold shares, the HUI Index, shot up as soon as the market read the statement sans that key sentence. Eurodollar futures further confirmed our thesis when they tightened by several basis points after the correction, that market now seeing a funds rate of only 3.75% by year`s end – which means a pause or two in the Fed`s quarter-point increases. 

Now if we can only see progress on the demand-side for liquidity from the developing positives on the fiscal front, there will be a further decline in the gold price, perhaps toward $400 oz. This will translate into a lower yield on the 10-year note, even if the Treasury follows through on hints that it will again issue the 30-year bond. A new 30-year issue in itself would be a positive move, given the bond market`s refusal to add much of an inflation premium to government issues. On this path, Fed Chairman Alan Greenspan and his FOMC would be more than red-faced with a statement bobble, having to explain why they should continue raising the funds rate when the long bonds are screaming at them that inflation is of no concern. 

As we noted Friday, Fed Governor Ben Bernanke did not vote yesterday, having recused himself while awaiting confirmation hearings for his nomination to be the President`s chief economic advisor. We`re eagerly awaiting those hearings because Bernanke will surely be asked about his recent comment that the "natural" funds rate may be below 3.5%, given all the information the market is feeding us. My expectation is that Bernanke will have more freedom at the CEA to speak his mind than he had at the Fed, and will be a positive force in elliptically nudging the FOMC toward an end to its rate hikes. Another personnel positive in this regard is the nomination of Bob Kimmitt to be John Snow`s deputy at Treasury. A protégé of James Baker III, Kimmitt may well pick up on Baker`s 1987 call for an international monetary reform, one that would require the Fed to target a "basket of commodities, including gold," instead of the funds rate. 

All this could happen in the next three or four months, with any luck, and that luck would have to come from House Ways & Means Chairman Bill Thomas. Indeed, the most likely reason for the Wall Street rally that kept the DJIA from sinking below 10,000 is the President`s commitment to Social Security reform and the Bill Thomas press conference last Friday. We posted excerpts from that conference at our public website, noting that he offered clues as to how he expects to have comprehensive reform legislation on the President`s desk addressing all the retirement issues. 

It`s still not apparent to the Democrats that Thomas hopes to replicate the strategy he employed in 2003 when he got a dubious Congress to pass the sensational tax package that has been essential to the economy`s expansion. If you recall, the President proposed elimination of the double-taxing of dividends, an idea that would have gone nowhere if Thomas simply rubber-stamped it and sent it to the House for a vote. Instead, he cobbled a partial cut in the dividend tax to 15% with a cut in the capital gains tax to 15%. The combination of a cut in capital taxation to mature corporations on their dividends and a cut in capital taxation to fledgling corporations with the lower capgains rate pulled the entire business community behind the legislation and made it impossible for Democrats to kill it in the Senate. Thomas built his support for it from the grass roots. 

That`s exactly what he now proposes to do with Social Security reform and tax reform. He clearly has that same broad outline, intending to merge the two reforms into one package. It would have so much appeal to different segments of the electorate that it will be irresistible to enough Senate Democrats that they will break ranks. And it will include personal accounts of some configuration, as he indicated at his conference. I believe that Thomas doesn`t know how it will look specifically when it hits the President`s desk, because he will need to maneuver bits and pieces in the negotiating process. But the fact that the GOP is in the majority on both sides of the Capitol and the President will sign whatever he delivers gives Thomas all the flexibility he needs to produce a winner. My reading is that from the very beginning Karl Rove, now deputy chief of staff and practically deputy President, saw the wisdom of handing Thomas the ball and giving him an extra-long leash to develop the strategy that will yield legislation. 

If my reading is correct, the hearings on Social Security will soon be underway in a subcommittee of Ways&Means, timed to produce the SSI components of the comprehensive reform legislation in late June when the Mack/Breaux Tax Commission makes its recommendations. What can go wrong? The geopolitical sphere is always a concern, especially with the way the neo-cons continue to demonstrate their clout at the Non-Proliferation Treaty Conference in New York, clearly aiming to provoke a clash with Iran over uranium enrichment. It`s something to worry about, but at the moment, we should be enjoying and celebrating the positive developments on the monetary and fiscal fronts.