If there was a Phillips Curve tradeoff between inflation and unemployment and a "neutral" federal funds rate to balance the two, it`s easy to imagine the U.S. economy being very close to the optimal rate right now. With overnight funds at 3% and the 10-year note just above 4%, the bond market is seeing a very low inflation rate over the near horizon. And with gold under $420 oz., behaving itself but not suggesting a new commodity deflation, at the moment there`s not much to worry about on the monetary front. The just-released Fed minutes of the last FOMC meeting even hint of new dovishness showing up, enough so that the futures market now forecasts the likelihood of a 3.5% ff rate in August to only 60% -- after it goes to 3.25% in June.
At the same time, the economy is hardly setting a blistering pace, growing somewhere in the 3% range. Nor is unemployment in the 5% range threatening an outbreak of "wage inflation," which some Fed governors worry about when they think too many people are going to work. Oil at $50 bbl is still a worry, but as long as gold is behaving itself in dollar terms and oil is priced in dollars, the tendency will be for oil to go lower, not higher.
Federal tax revenues are rising faster than had been forecast and for the most part state and local budgets are under control. The recent rally on Wall Street has been comforting too, indicating a sound economy in the months ahead. Things would look even better if the Dow Jones Industrials would again threaten 11,000 before the summer is out. The NASDAQ`s more robust move in recent weeks offers another happy note, indicating productivity will not be slipping soon. We do want those FOMC governors to keep inching down that dovish path.
What has brought about this conjunction of favorable economic signs and portents? And how long can it last? With such small changes in the various auction markets, it is difficult to assign reasons for the changes with a high degree of confidence. Why, for example, has gold come down, lifting the dollar against the euro and yen?
It would be consistent with what we have been saying all year that we would see an increase in the demand for liquidity and downward pressure on gold if there would be signs of progress on tax and Social Security legislation or on Sarbanes-Oxley regulation and enforcement. Much of the dollar weakness into April seemed, to us at least, clearly related to the reform ideas failing to excite the electorate or Congress and to the failure of the SEC or Treasury to moderate SOX. Has there been any change in these fortunes that we might connect with the pleasant news from the auction markets?
Our Democratic friends continue to tell us the President will fail in his attempt to get personal accounts in whatever might be done on Social Security. But House Ways & Means Chairman Bill Thomas continues to act as if the Grand Mosaic he is designing for both tax and retirement reforms will succeed in breaking into the solid front of Senate Democrats. One K-Street tax lawyer who gets as close to Ways&Means as anyone we know outside Congress tells us he thinks the Grand Mosaic will include lower tax rates on capital gains, for sure. We should expect that piece to come out of the Mack-Breaux Tax Commission when it reports next month. Maybe, maybe not. But the Democrats who are close to these issues surely know the entitlement deficits can`t be "solved" unless the capital/labor ratio goes up by 50% in the next dozen years. Even a whiff of lower tax rates on capital gets NASDAQ a bit dizzy.
It would be nice if Thomas could somehow find a place for a SOX reform in his Grand Mosaic. We`ve been saying since 2002 when SOX was enacted that it took 800 to 1000 points off the DJIA as it was being enacted, translating into 10% of all traded equities or between $1 trillion and $1.3 trillion. We were being slightly conservative, at least compared to a recent paper by Ivy Xiying Zhang of the William E. Simon Graduate School of Business Administration at the University of Rochester. He apparently had the same idea we had. According to the London Economist, Zhang looked at the decline in the market cap at the time SOX was being enacted and figured "the costs minus the benefits as perceived by the stock market" at $1.4 trillion. Says the Economist: "If this number were true, SOX would have to prevent an awful lot of unforeseen losses due to fraud before it could be judged a good buy." No kidding.
With this kind of attention, it seems most likely that the administration and Congress will get around to doing something about SOX, maybe not enough to tack 1000 points on the DJIA, but maybe enough to add 500. The news that 14 Democrats and Republicans got together to work out a deal to save the Senate filibuster from the GOP "nuclear option" on judicial appointments did not do a great deal for asset values on Wall Street, but it did a lot for the bipartisanship it will take to work out the kinds of reforms Bill Thomas will have to work out with Senate Finance and the White House. And I still believe a Senate defeat of John Bolton as U.N. Ambassador would be a positive for the President`s domestic legislative agenda, further fostering a bipartisan spirit. The Democrats will work with the President if they can become part of the action and share in the credit. Letting the Democrats have Bolton`s scalp would have that effect – and save the President from having to fire Bolton when he proved a loose cannon at Turtle Bay.
The other clouds we discussed earlier this month relating to foreign policy are also looking brighter for the moment. Iraq remains a mess, but Iran seems to be working things out with the Europeans over the nuke issues, and if Mahmoud Abbas can get some support for the Palestinians in his meetings with Mr. Bush and his team this week, we can keep hoping for progress in that corner of the Middle East.
It`s rare these days when we can look around and not see several crises threatening simultaneously. We finally have a patch of blue water and can proceed, maybe not in spectacular style, but at least at a nice, steady cruising speed, and hope it lasts.