The Perpetual Motion Inflation Debate
Jude Wanniski
August 17, 2005


Normally, it has been the observation that Wall Street is blessed by summer rallies, coincident with Washington, D.C. shutting down. The exception this year is because  Alan Greenspan and his Federal Reserve colleagues continue to show up for work, raising interest rates in its failed experiment to pre-empt inflation. Worse, the inflation it has created by reducing the demand for liquidity is now showing up in the statistics, persuading the folks at the Fed that it has to go considerably farther than the current 3.5% fed funds rate which not too long ago seemed like a good place to stop. In this case, we are eagerly awaiting the return of Congress after Labor Day in the fading hope that it may produce legislation that will increase the demand for liquidity and turn off the Fed’s perpetual-motion machine. 

What worries me most about the extension of Fed policy is that there are practically no voices being raised against it. This is the problem with being practically the only analyst who fought the experiment from the very beginning. If we are right then everyone else has been wrong in believing that higher short-term rates will reduce inflation expectations – accompanied by a decline in the price of gold. To remind you, the three major newspapers – the Times, Journal, and Washington Post – have supported the Greenspan quest for the magic “natural” interest rate that will produce optimum low inflation and unemployment. I don’t know of a single metropolitan paper that has taken our argument that we were in heaven when the funds rate was at 1% in June of last year – when the Fed decided it had to do something to stamp out an inflation that was non-existent.

If the major opinion journals are hooked on Fed policy, that only reflects the fact that all corners of the economics’ profession are in agreement. It is nice to see Larry Kudlow on CNBC, an early supporter of the Greenspan experiment, almost daily blasting the idea that higher rates are called for – and suggesting the Fed take six months off. But the Wall Street Journal remains adamant, backed by the boys at Bear Stearns who think the gold bubble (now $445 oz compared to $398 oz at the start) will “pop” when the funds rate gets up to 4.5% or higher. Here is Bruce Bartlett today, writing from his post at the National Center for Policy Analysis:

<blockquote>The problem is that just because the Fed is raising rates gradually doesn’t mean that the impact will be gradual. It could come quite abruptly. Think of a balloon. Whether you blow it up slowly or fast, at some point it is still going to burst. The same thing often times occurs with monetary policy. It may appear that nothing is going on for a long time and then, suddenly, something dramatic happens to show that monetary policy is working as expected. Another problem is that the Fed’s policies always take time before they impact and these lags vary. So it’s very difficult to know precisely when the impact will be felt.

This is all nonsense, if it is expected that at some point the “gold bubble” will “pop.” Prices of many goods would decline in the midst of an economic recession, with companies trying to unload inventories at distress prices. When inventories are liquidated, though, those still standing have to pass through higher wage and commodity costs to expect a positive ROI. But who is going to dump gold when it is about the only investment that is holding its value in real terms? Remember, it isn’t a weaker economy with slower GDP that worries us with a climbing federal funds rate. It is the effect this has on demand for dollar liquidity, which pushes up the dollar/gold price and translates into higher long-term rates. In that kind of scenario, with gold climbing to a higher plateau, the dollar/oil price will move up in tandem. Oil prices in euros, yen or Chinese yuan, though, could remain stable, as their central banks are now de-linked from the Fed’s perpetual-motion inflation machine. 

Those who are defending Fed policy and yapping about how good the U.S. economy is doing, Bear Stearns again coming to mind, are buoyed by equity prices on Wall Street, which are still hanging in there after the run-up earlier this summer. But if you use a gold deflator, the stock market does not look even that good. Between June 30, 2004 and today, in nominal terms (not adjusted for gold), the S&P 500 is up 7.4% and the Nasdaq is up 5.1%. Adjusted for gold, though, the S&P 500 is down 3.7% and the Nasdaq is down 5.8%. You can say that the dollar has not lost that much purchasing power against a broad basket of goods and services, so equities are still ahead of inflation. But you can see that over a longer term the gold deflator has plenty of disturbing information, especially as oil is generally the first commodity to react up or down to gold. 

We had hoped to see a break in the ranks of the Federal Open Market Committee by now, with someone or other citing the rise in the gold price and wondering if there should not be a pause in the quarter-point rate hikes. Ben Bernanke was the Fed governor who opined some months ago when the funds rate was below 3% that maybe the “natural rate” would be under 3.5%. But since Bernanke has moved to chair the President’s Council of Economic Advisors, he has been mum on monetary policy, and we hear he believes the CEA has to steer clear of Fed policy. Minutes of last week’s FOMC meeting will not be available for another two weeks, but we are not getting our hopes up for a break.

On the demand side of money, hopes are also fading for meaningful reform legislation out of Congress this year. Congress may just run out of time and energy in the closing months of this year’s session, but at least can get things started for completion next year. Estate taxation, AMT reform, or best of all a commitment from the President to go for a flat tax a la Steve Forbes, would spur an increase in the demand for money and get the gold price back in less anxious territory. If our new SEC chairman, Bill Cox, follows through on his recent promises to water down the worst features of Sarbanes Oxley we would also get relief. Without something of that sort, we have to be prepared for the Fed doing what it’s doing, in perpetual motion at a measured pace, until Greenspan retires.