In our “Fedwatch” item yesterday, David Gitlitz noted an array of forces at work that seem to be driving the dollar/yen rate back toward 90, perhaps 100. The Fed’s decision to stay out of the market today at a time when it was assumed it would add reserves tends to confirm this analysis. As long as the Fed is going to be stingy with reserves, trying to persuade the markets that short-term interest rates will not be falling soon, the dollar price of gold will continue to slide as the increased demand for reserves is not being met. This automatically translates into a stronger dollar against the yen. The Bank of Japan could resist the weakening of the yen, but why would it? It has been trying to weaken the yen by lowering interest rates.
Why is there an increased demand for dollar reserves? The markets see the political psychology of a weak economy playing into the hands of the forces of growth. The fact that the 104th Congress is controlled by Republicans who want to cut tax rates, especially giving relief on capital gains, can only be good news for the markets. Note how the Clinton economic advisors are screaming about the depressing economic effects of budget balancing! The Republicans are enjoying the luxury of control, making arguments for tax cuts instead of spending increases. The pressure the GOP is putting on the budget by slashing everything in sight puts them in a strong bargaining position when the arguments arise over tax cuts. It is now entirely conceivable that when the Congressional Budget Office lops 2 percentage points off long-term interest rates, which produces $170 billion in tax revenues over seven years, it will be able to follow with a dynamic scoring that will add another $160 billion for economic growth. This pool of funds shows up magically out of the Keynesian model used to program the CBO computers. The Democrats cannot argue that it is supply-side smoke and mirrors. They can only argue that it should not all be spent on tax cuts. At that point, the Republicans would be able to cut a Big Deal, one that restores funds to programs near to the hearts of the liberals -- Big Bird, Howard University, summer jobs, etc.
The trend thus is now entirely in the direction of an increase in the demand for dollar liquidity, which reverses the “treadmill effect” that results from the Fed targeting interest rates. As enterprise now expects interest rates to go lower in the future, there is no need to borrow in order to beat higher rates and the fed funds rate will trade below 6%, inviting the Fed to drain reserves in order to maintain that rate. An increase in the demand for credit will be matched by a decrease in the supply. Either gold falls in price or the Fed cuts the funds rate. The likelihood at the moment is that the Fed will stand pat, which leads us to expect a lower gold price and a stronger dollar against the yen. The nice thing about this convergence is that it does not require any policy change at the Fed or the Bank of Japan. It should unfold especially if all the central bankers go on vacation. The problems develop when the gold price gets so low that deflation bites into the real economy. The Fed would have to cut rates as gold approached $350, which is what Alan Greenspan did the last time he maneuvered us into a bond-market boom. All in all, by this analysis, we can see the forces in place are fairly bullish for the near term.