The Threat from the Fed
Jude Wanniski
August 4, 2005


The two-week rise in the dollar/gold price to $443 from $418 reflects the decline in the demand for dollar liquidity accompanying Fed Chairman Alan Greenspan`s signal that the Fed will keep raising short-term interest rates until it succeeds in slowing the economy. The goal set 14 months ago when the Fed began raising the funds rate in quarter-point increments, to the present 3.25% from 1% back then, was to find the "natural" rate that would balance the twin objectives of low inflation and low unemployment. Those objectives seemed to have been met when the CPI was clocking 2% or less and the unemployment rate came in at 5.1%, which not long ago would have been considered abnormally low. Now, there appears to be a brand new goal, slowing the economy down for its own sake, an objective that would increase both the rate of inflation and the unemployment rate. Unless we see dissenting views at next week`s FOMC meeting, this would be a more serious threat to stocks and bonds than anything else we see on the horizon.

When the Fed began its experiment a year ago, we were almost alone among Wall Street analysts in arguing that raising the funds rate to slow the economy was in itself inflationary. The 1% funds rate was thoroughly compatible with a gold price of $398 at the time; the slight inflation at that price implied a CPI of little more than 1% annual rate averaged over the following decade. By adopting a Keynesian policy that assumes inflation is caused by too many people working -- an idea embodied in the Phillips Curve tradeoff -- the Greenspan Fed essentially announced to the markets that there would be less need for dollar liquidity in the future. The economy would need fewer transaction dollars in an economy growing slower. Under a gold standard, the surplus liquidity in the system would automatically be mopped up by the sale of bonds from the Fed`s giant portfolio and gold would have remained at $398. Without such a mechanism, dollars became plentiful relative to gold and the gold price drifted upward.

As a result of the Fed`s failed experiment, there is now MORE inflation built into the system, which is why the yield on the 10-year note has climbed over the last month to 4.3% from 4%. The more serious problem is that Greenspan, in his last months as Fed chairman, may be determined to push harder on his failed experiment – like the fanatic who doubles his speed when he loses sight of his goal. Wednesday`s front-pager in the Wall Street Journal by Fed correspondent Greg Ip, "Fed Sees Bond Market Hampering Its Steps to Keep Inflation in Check," is almost scary in its implications.

As the Federal Reserve prepares to raise short-term interest rates again next week, officials there increasingly believe the bond market…is diluting their efforts to tighten credit and contain inflation. The result: The longer the bond market keeps long-term interest rates unusually low, the further the Fed is likely to raise the short-term rates it controls in an effort to keep the economy from overheating. Conversely, sharply higher bond yields would encourage the Fed to stop raising short-term rates.

You can see where this leads. Greg Ip says former Fed Governor Laurence Meyer, a dyed-in-the-wool Phillips Curver, "thinks the Fed eventually will raise its short-term rate to 4% from today's 3.25%, if bond yields rise significantly. If long-term rates don't rise, the Fed will have to raise short-term rates above 4.5%." But then, higher bond yields reflect higher inflation expectations. If the Fed believes the 10-year note should really be closer to 5% than to 4.3%, it will keep to its track as gold moves over $500 down the line. It isn`t easy to get the yield up that high without inflation expectations and they won`t show up unless the higher funds rate drives down the demand for dollars and thereby increases the dollar/gold price.

We`re not alone in seeing the nuttiness of the scenario outlined by Greg Ip. Larry Kudlow on CNBC's Kudlow & Company last night practically had a conniption over the Ip story, denouncing Greenspan & Co. for their foolishness. Unfortunately, he did not make the connection to the rising gold price, only to the inferred aim of driving down the prices of stocks and bonds on purpose. Kudlow seemed to ascribe the surge in gold to China`s decision to delink to the dollar, an idea we briefly considered and dismissed. If one buyer of dollars in the world decides to buy fewer, for one reason or another, the excess would show up as an increase in the 3.25% funds rate and the Fed would have to mop up enough liquidity to get funds back to target.

It would be nice if there were policymakers in the government reacting adversely to the implications of the Journal story, to at least generate discussion about this latest threat from the Fed. The President, though, is on vacation at his Crawford Ranch. The Vice President and Karl Rove are distracted by the Valerie Plame affair, waiting for the federal prosecutor to make up his mind on possible indictments. And Congress is in recess. Ben Bernanke, who had a large hand in designing the failed Fed experiment when he was a Fed Governor, is now at his desk as chairman of the Council of Economic Advisors, but he has been mum on monetary policy so far. We have our fingers crossed that one or more members of the FOMC will raise some embarrassing questions at next week`s meeting. The minutes of the last meeting for the first time hinted at policy being questioned, even though Greenspan again rounded up a unanimous vote for a rate hike.

What happens in this monetary realm has an effect on practically everything in the world economy. The U.S. dollar economy is still the dominant force in the world, and a weakening of the economy or a weakening of the dollar will sink the equity markets of those economies that trade heavily with us. And of course as the dollar/gold price rises, there is more incentive of the OPEC nations to keep dollar/oil prices high. At $500 gold, if it gets there on a worst-case Fed scenario, oil would go to at least $65, perhaps $70. If you happen to know a member of the FOMC, please drop them a note.