Fedwatch: Next Week and January/Presidentís Speech
Jude Wanniski & David Gitlitz
December 15, 1994



We now take as a given Monday's New York Times report that the Fed next week will likely refrain from moving up rates for the seventh time this year. Yesterday's Times front page piece on Orange County's concern that the Fed will raise rates again before it can get control of its financial crisis almost assures us that the Fed will pass next week. Keith Bradsher's Monday article focused on indications that several FOMC members, particularly vice chairman Alan Blinder, would rather await additional data on the real economy -- such as retail sales, factory orders and employment -- before moving again, probably in late January. As far as Greenspan is concerned, we don't think this data should be nearly as important as information the market is throwing off, that inflation expectations generated a year ago have now been sufficiently dealt with and absorbed by the rate hikes to date. With this information in hand, he can make the case within the FOMC (and to the world at large) that there is no further need for tightening.

The bond rally since late November is providing much of this information, the gold market the rest. By dropping 30 basis points, long-term yields are assuring Greenspan that he has successfully swallowed the easy-money error the Fed made last year when the price of gold climbed 10% to $385. With gold declining $20 from its $400 peak of September 27, that market is also telling him it has digested the error. If he were to now raise the fed funds rate another 50 basis points, as Wayne Angell insists he must, the overkill would only flatten the yield curve to the point of inviting recession next year, with the markets being asked to swallow and digest another adjustment of prices. We know this was on Greenspan's mind from his testimony last week before the Joint Economic Committee, when he noted that the inflation apparent in intermediate stages of production could soon pass through to finished goods. The core intermediate goods component of the producer price index has been moving up at an annual rate of more than 8% the past four months. It registered a 0.9% increase for November alone, a four-year high. 

In our analytical framework, the Fed should have gone through this adjustment process by draining reserves to get gold back to $350 and then keeping it there. The funds rate would have risen, but long rates would not have, we believe, thus getting us to this point of the yield curve much sooner, and with much less distress. The Fed may get into our framework someday, especially as a result of Greenspan's experience this year, but in playing out the hand it began in February, it may be clear that there is now no need for additional rate increases for as far as the eye can see. Having swallowed and digested the error, we see no point in now driving gold back to $350, which is probably what Angell has in mind. What happens in the next six weeks may produce another horizon on this policy track that would call for higher rates. At the moment, though, the nation's creditors have already discounted for the inflation now in the system. In vaporizing about 20% of the value of 30-year Treasuries since last October, bond prices more than absorbed the risk for the erosion of dollar purchasing power evident in the higher gold price. After testing $400, gold is now back below $380, and the dollar's foreign exchange value has recovered to about 100 yen, after threatening to drop below 96 yen earlier in the fall. 

With all our sniping at Greenspan, we do after all have to acknowledge that he did not allow his first error to compound, or we would have seen gold climb above $400 and stay there. From its first real tightening September 28, the Fed has also shown recent resolve by draining some $14 billion from the banking system in the first week of December. This undoubtedly has helped give the bond market a firmer tone. The political problem for Greenspan is that the inflation that has been in the system for the past year is now surfacing in the statistics. When the PPI numbers begin showing up in the consumer price indices, he will have to explain that this is the residue of the problem he identified a year ago, when he was being criticized for fighting a phantom inflation.

What might happen between now and the January FOMC meeting? For one thing, there will be a Republican Congress that will not want to be blamed for a 1996 recession and a Democratic President who will not want a 1996 recession. In the best of all bipartisan worlds, we will get an agreement on a capital gains tax cut. House Minority Leader Richard Gephardt will try to rally his troops against capgains, but won't succeed. President Clinton's nominee for Treasury Secretary, Bob Rubin, will face confirmation hearings in January before a Senate Finance Committee chaired by Sen. Bob Packwood (whose staff believes a capgains cut is practically in the bag). Our best guess is that something will be worked out. This will mean a continued rise in consumer confidence, an increased demand for the dollar, and more market signals than Greenspan needs to declare victory over inflation.

David Gitlitz


Tune in tonight to hear the latest installment of "Class Warfare, U.S.A." The President will propose a tax cut for the middle class, as opposed to last year's tax increases for the upper class, which wound up including tycoons earning more than $30,000 a year, or last year's Earned Income Tax Credit, which targets subsidies to the poorer, working class. The President's helpers are struggling to design a child credit that gives full credit to families earning up to $60,000, provides less credit between $60,000 and $100,000, and no credit for rich kids. The little elves argue that nearly two-thirds of taxpayers have no kids and would not benefit from the GOP plan, which phases out above $200,000. Unlike the President's plan, the GOP plan does not target kid classes within kid classes. According to the Times today, the White House will propose "about $50 billion in income tax cuts, probably through a mix of tax credits for families with pre-school children and new deductions for college and technical education...Perhaps $35 billion in cuts over the next five years would come in the form of a $500 per child credit for families earning less than $100,000 a year, with another $20 billion in tax deductions for post-high school education." If there is any mention of a capital gains tax cut, it will be carefully targeted to benefit people without any capital, which means there cannot be a capital gain, and therefore no cost to the government. People who already have capital already have too much, so they will not be allowed to benefit by investing in poor people who need capital in order to get rich. In a note Wednesday to the party's chief class warrior, House Majority Leader Dick Gephardt (for a few more days), I explained: "The middle class does not want a tax cut. The lower class does not want a tax cut. The upper class especially does not want a tax cut. All classes want the economy to move into higher gear, in a way that benefits all classes. The best way to do that through tax policy is to index the capital gains tax backwards and forwards. This removes one of the greatest threats to capital formation in our system, at the lowest cost in static terms...The mistake you are continuing to make is to `target' a class for benefits, which is an idea that will always be rejected by Americans in the aggregate, because it is essentially un-American." Alas, President Clinton, "New Democrat" or Old, remains the victim of his scientific political advisors, who think the Democrats crashed on November 8 because they did not pass out enough free pizzas and beer to the Reagan Democrats who deserted them. This scientific practice began in 1972, when Democratic presidential nominee George McGovern promised a $1,000 "demogrant" to all taxpayers with incomes below $17,000, a number arrived at by the pols who figured that number would include everyone who might vote Democratic. McGovern lost to Richard Nixon in the biggest landslide in U.S. political history.

Jude Wanniski