A Leaky Faucet at the Fed
Jude Wanniski
June 7, 1991


As the price of gold continues to inch upward toward $370, the bond market and the stock market drift lower. The rising gold price, of course, continues to reflect the error made in monetary policy April 30 when the Fed was jawboned by Treasury Secretary Nick Brady into cutting the discount rate a half point to 5.5% and, more importantly, shaving the fed funds rate a quarter point to 5.75%. Fed governors like to remind themselves that it is practically an iron-clad rule that when they have been in an easing mode or a tightening mode, they always seem to go one step too far. They have done it again. Gov. Wayne Angell, who cast the lone dissenting vote, agreed with his colleagues that the economy was as weak as they believed, but held that there was no more room on the monetary side to bring relief. The yield on the 30-year bond, at 8.17% when the Fed acted, is now creeping toward 8.5%.

Shaving fed funds a quarter point might not seem like much, but like a bathtub's dripping faucet, it will eventually flood the system unless it is corrected. In keeping fed funds at 5.75%, the Fed's open-market desk in New York is forced to dribble more liquidity into the banking system than the market desires. As the most sensitive barometer of incipient inflation, the gold price floats up on this surplus liquidity, dragging bond yields along. If the Fed had been too tight, as Secretary Brady thinks, a rising gold price would be lifting the stock market, as has happened several times in the last 20 years. Now, though, rising gold batters stocks, as the market calculates the increase in the capital gains tax on financial assets, which are not indexed against inflation. A sliding stock market, of course, anticipates a smaller economy. To coin a metaphor: The bathtub is shrinking while the faucet continues to drip.

How to fix it? Either stop the dripping or expand the bathtub, naturally. Good news is required on either method. The sacking of Secretary Brady by President Bush would be extremely good news, but as Mr. Brady is the President's closest friend, this is unlikely. Another possibility is that President Bush might suggest to Mr. Brady that he stop imploring Chairman Greenspan to open the liquidity spigot some more, as Brady did in yesterday's issue of American Banker. This is also unlikely, as President Bush's chief economic advisor, Michael Boskin, also has not noticed that the bathtub is running over. The reappointment of Chairman Greenspan by President Bush would also be good news. It at least introduces the possibility that Mr. Greenspan will have a free hand to work the faucet.

After all, if the financial markets are unhappy with the drip-drip of liquidity at 5.75% fed funds, they should be happier at 6%. According to the financial press, unfortunately, there is no discussion to be found anywhere of "snugging up" to 6%. If Chairman Greenspan even hinted at such a move, Mr. Brady would undoubtedly have a conniption. The Treasury Secretary and his henchman, David Mulford, are frantically trying to get the central banks of Europe to flood their bathtubs in advance of the London economic summit.

The alternative is to expand the bathtub at home. Cutting the capital gains tax would be the most efficient way of doing this. Indeed, a cut in capgains would expand the tub so rapidly the Fed would have to open the faucet more to maintain the liquidity level. This is why the Federal Reserve governors would unanimously support a cut in capgains, but nobody seems much interested in their views on the size of the bathtub. President Bush's request, in his State of the Union Address last January, for a "Greenspan Commission" to study the connection between faucet and tub, remains stalled by the congressional Democrats. Budget Director Richard Darman hints the President might ask the Commission to proceed anyway. It remains our fervent hope that Mr. Darman, said by many to be the smartest man in Washington, will notice the tub is overflowing and, unlike Mr. Brady, either conclude the faucet should be tightened, not loosened, or that the tub must be expanded by tax cuts, not increases.

How deep do things have to get in stocks and bonds before President Bush loses his patience with his economic team? We're told he's getting edgier by the hour, but that news no longer comforts us as much as it once did. Until we actually see him kick a little a--, we are going to drown our sorrows. Drip, drip, drip.