On November 2, 1983, my client letter "Volcker's October Deflation," began: "For more than a year, the price of gold has remained above $400, usually in the vicinity of $425. In October, the price plunged below $400, ending the month 10 percent below $425 as Fed Chairman Paul Volcker renewed vigorous pleas for fiscal belt tightening and worries about inflation." The report was that Volcker would have preferred gold to stay above $400, but considered it a false signal, that economic growth was signaling renewed inflation and the falling gold price was an anomaly. He wasn't satisfied with the squeeze until gold hit $274 in February 1985, the dollar hitting its peak on the foreign-exchange markets, the U.S. economy hobbled by the wicked deflation, federal deficits climbing back toward $200 billion.
Here we go again — but with a few important differences. The Fed has been reacting to arguments that the current level of economic growth is inflationary. The gold price, hovering between $425 and $450 for most of the past year, has tumbled to $395 as the Fed withholds the level of liquidity needed to keep it steady. The dollar is climbing on the foreign-exchange markets, but unlike 1983, foreign central banks are now tightening through the intervention process in order to slow the dollar's advance. There is some risk of a new global deflation unless the process is soon arrested. Five years ago, the Fed's Vice Chairman, Preston Martin, stood alone in making these arguments. Today, there are several Fed governors who are nervously watching gold flit below $400 as policy keeps the critical fed funds rate at 8 1/4 percent, too high to arrest gold's decline and thus permit a healthier level of economic growth.
Governors Angell, Seger and Kelley are in the vanguard of the anti-deflationists. My guess is they would now like to see fed funds eased to 8 l/8th, then 8 percent, testing the impact on the gold, commodity and foreign-exchange markets. Governor Heller is probably content for the moment, but would join the others if the dollar strengthened and the gold price fell. Vice Chairman Manuel Johnson is probably hoping the elections are over and done with six weeks from now before the deflation signal gets stronger. Chairman Greenspan is in the same boat, hearing from the regional Fed presidents that inflation is still the main concern. He'd like to maintain a polite consensus.
We'd like to say with certainty this time around that the good guys will win. But we thought Volcker had seen the light five years ago. At the time, we specifically warned that another deflation would crunch the banks and S&Ls and perhaps bankrupt the FDIC, and he seemed to understand. Now, the guessing game in Washington and Wall Street is whether a bailout aggravated by Volcker's 1983-85 deflation will exceed $50 billion or $100 billion. A failure of the Federal Reserve to prevent yet another deflation would have us talking even bigger numbers, widespread Third World defaults, and soaring federal deficits.
The foreign central banks should not have to tighten to prevent the dollar's advance. Gold falling under $400 should be the signal that it's the Fed's turn to act, by easing on short rates to bring balance to gold, commodities and the DM and yen rates. Any sign that such a move is getting serious consideration would buoy the financial markets.