The Fed 'Conundrum' and Dollar Demand
Jude Wanniski
June 22, 2005

Roger C. Altman, an investment banker who was deputy Treasury Secretary in the Clinton administration, thinks he has figured out the "conundrum" posed several weeks ago by Fed Chairman Alan Greenspan. The Wall Street Journal which seems to agree with his thesis, gave him an op-ed slot Tuesday in "The Conundrum Explained." Says Altman: "Three alternative schools of thought have emerged to explain it. One is that the bond market has overshot. A second is that the growth outlook is actually weaker than the consensus forecast, and the bond market is discounting such slower growth before it manifests itself. But the right answer involves excess global liquidity which, for the moment, has nowhere else to go but into dollar-denominated fixed-income assets like U.S. Treasury securities."

We of course agree that the first two schools of thought are wrong. The bond market is as efficient as the broad stock market and does not overshoot or undershoot, given the information available to everyone. Nor does the efficient bond market expect a weaker economy, for if it did the efficient equity market would not be expecting a stronger economy. Altman`s assertion that "Historically, long-term interest rates rise when the U.S. economy is strong, and fall when it is weak," is mere assertion. Remember the marvelous Reagan expansion of the 1980s, with the stock market climbing and long-term interest rates falling?

The "right answer," according to Altman and to Bear Stearns` David Malpass, who got there first, is that the Fed has been printing too much money and Americans have been using it to buy foreign goods. Foreigners, including foreign governments, instead of using the dollars to buy U.S. goods, are using them to buy U.S. government bonds, thereby keeping the 10-year note near 4% when it should have climbed to 5 1/2% or 6% by now, with the Fed having pushed the funds rate to 3% from 1%.

The flaw in this argument is that when the Fed prints too much money relative to demand, the first thing that happens is the dollar price of gold rises, gold becoming scarce relative to paper. The second thing to happen is that the banks holding this excess liquidity try to find eligible customers to take it off their hands, as dollars do not pay interest and are costly to hold as surplus reserves. But because all eligible customers had already been satisfied prior to the Fed`s printing of too many dollars, the banks (or other financial intermediaries) must take greater risks with customers who normally couldn`t measure up with sufficient collateral. These are the basic mechanics of an inflation, of course, and they are never accompanied by falling bond yields.

In 1979-80, when the Fed flooded the system with dollars, Citicorp "solved" the problem of surplus inert reserves by lending them by the billions to foreign governments on the theory that governments would have to pay back the loans by taxing their people, even if the loans went bad. Mexico borrowed $80 billion, advised that oil would soon be $75 bbl and they would be able to pay it all back and have a fortune in profits. There was no "conundrum," though, and long-term rates on U.S. governments went over 13%.

Altman gets around the current "unprecedented phenomenon" by pointing out that Japanese 10-year bonds only pay 1.3% and German 10-year is at 3.3%, so the U.S. bond at 4% is the best buy on the global market!! In other words, by this circular reasoning, the 10-year note is at 4% because the 10-year note is at 4%. One wonders if the <I>Journal</I> actually paid Mr. Altman its usual modest fee for his discovery.

Most of you, as clients, are by now well familiar with our "conundrum" thesis, but I`ll go through it briefly before getting to the second part of this paper on how the declining demand for liquidity has pushed gold back close to $440 oz.

It has been our observation that the monetary inflation unleashed by Richard Nixon in 1971 put in motion a 1000% rise in the dollar gold price, from $35 oz to $350 in 1985. We choose 1985 because gold stabilized at that level for several years until the 1993 Clinton tax increase (engineered by Roger Altman) caused a decline in the demand for dollars and pushed gold to $385. It was the 1997 tax cuts that raised the demand for liquidity and sent gold as low as $255 in 2001, a serious deflation. Then 9-11 and a series of restrictive regulatory measures (Sarbanes-Oxley the worst of them) again diminished the demand for liquidity and gold climbed back to $350.

It was at this point where it could be shown that all the inflation Nixon put into motion in 1971 had been washed out. In our March 1 letter, "Greenspan`s Conundrum Explained," we ran a graph plotting the Consumer Price Index against the gold price since 1947. It shows the CPI finally catching gold two years ago at roughly $350.

If we are correct and gold is the most monetary of commodities, this means that inflation expectations two years ago had also been washed out and interest rates on the 10-year would be below 4%. With the yield curve reflecting that condition, the federal funds rate properly belonged at 1%, which is where it was 50 years ago before the government began fooling with the dollar. I`ve not made the point before, but this also explains why Japan`s and Germany`s 10-year bonds are now where they are. They have washed out the embedded inflation that also began in 1971, but the Fed`s dubious experiment with raising the funds rate has begun a New Inflation. The policy has helped bring gold to its current $437, which implies a very modest inflation over the next several years while the parallel gold prices in yen and euros imply a continued deflation in Japan and a very modest inflation in Europe.

Those of you who have accepted our analysis have correctly assumed that the recent climb in gold from $417 to $437 is not the result of "fears" that the Fed will not raise interest rates as much as they need to (again Bear Stearns), but the setbacks the Bush administration has felt recently on its tax and pension proposals. The jump in gold was coincident with news that the Mack/Breaux Tax Commission, which was expected to have reported at the end of this month would not do so until the end of September. I have to assume that House Ways & Means Chairman Bill Thomas is still working on his Big Mosaic, which he believes will solve several legislative problems at once. But I`m as helpless to explain what`s going on in his mind as I am when watching Gary Kasparov planning his next moves against Big Blue. My best guess is there are enough positive moves on fiscal policy ready to be made that I`d be surprised if one or more don`t come through. That would mean a decline in gold and a firming of the dollar and dollar bonds. The news today that the Senate is close to a deal on the estate tax was nice to hear. I can now easily imagine a final deal making permanent a $10 million exemption per person and a 15% rate above that level, which is the proposal of Senator John Kyl [R AZ].

The other good news was the Senate`s defeat of President Bush`s ill-considered nomination of John Bolton to be the country`s Ambassador to the United Nations. Mr. Bush still wants the Senate to try and try again to get confirmation, but that hardly seems likely. If the White House agrees to turn over to the Senate the material the Democrats are demanding, it would not only sink Bolton more quickly but also open up a new can of worms for the White House. The White House is threatening a recess appointment of Bolton, but the Washington Post may be correct in saying if that happens, the administration is unlikely to get a single piece of important legislation through the Congress this year. My advice to those in the administration, who are still listening, is that the President propose a Democrat to the post, not another neo-con agent. If he does pick a good one, he could turn his popularity numbers around in a hurry, all over the world.

[Dear Clients: I want to add a note of thanks to you for your continued support of Polyconomics and our research work. The last two years have been the most difficult of the 28 since we began. Some of our most faithful, long-standing clients fell away, the victims of New York Attorney General Spitzer`s shotgun approach to cracking-down on soft-dollar independent research. We`ve also lost others because of our controversial analysis of events in the Middle East, but some of those I`m happy to say have returned as it has become clearer that our work has stood up to the test of time. Thanks again to those of you who hung in with us during our most trying times.]