Thinking about Deflation XII
Jude Wanniski
October 26, 1998

We may have been right when we noted on September 1 that the Dow Jones Industrial Average may have hit bottom, on the assumption that the steep decline the day before served as ďA Kick in the PantsĒ to Fed Chairman Alan Greenspan. The DJIA came close to that low point at the end of September but has been climbing ever since Greenspan carried through with its cuts in the fed funds rate, to 5% from 5.5%. The smaller cap stocks of the Russell 2000 did not bottom with the DJIA. After a brief rally, the Russell sharply fell again until it bounced on October 13 at 320.3. In the same period, the CRB index of commodity prices finally bottomed on August 28 at 195, hitting its recent peak of 206 ten days ago following the second rate cut. Gold briefly touched US $300 at this point, probably on expectations the monetary ease would send gold up. As we expected, though, the lower funds rate would invite liquidity demands as great as liquidity additions, and gold has since slid back toward $290. The monetary deflation is not over and the threats to the smaller cap stocks and the national economy are not over. We can see, at least, that the commodity deflation poses the greatest risks to smaller entities and that a correction of the problem will find the greatest gains to those assets that have taken the biggest hits. The bounce back in Asia, where currencies have been liberated from the dollar deflation and are beginning to see the second-order effect of lower prices on the goods and services they import, is further evidence of the adjustment.

Still, there is no guarantee the global demand for dollar liquidity will not continue to outpace supply, which is all it takes to begin a new round of deflation. If gold continues heading south, the CRB index will follow and so will the Russell 2000. I canít stress enough the importance of Jack Kempís appearance on "Evans&Novak" last weekend, when he was asked if he was happy now that Greenspan was lowering interest rates. Kemp said he was not, because the objective was to raise the gold price to at least $325 by the Fed injecting bank reserves sufficient to raise commodity prices to safe levels. Kemp noted that Steve Forbes has now urged liquidity adds to get gold to $350 and said when gold got between $325 and $350 it should be stabilized, but not before. Former Fed Governor Wayne Angell, now at Bear Stearns, says gold should be at least at $300 and hints that Greenspan would like to get it there. But unless Greenspan himself begins to talk about hitting a dollar/gold target, the risks of a near-term deflation and a longer-term inflation remain. On August 9, Kemp sent Greenspan a note asking if he would not prefer to see gold at $325, but Greenspan has not answered it. The silence at The Wall Street Journal has been deafening on this critical issue. Intellectual progress toward escape from this deflationary liquidity trap canít be made until the Journal decides it has to support Kemp and Forbes.

The Catch-22 is that as all other risks to investment in the United States decline -- including threats to the Clinton presidency -- the demand for liquidity rises and revives further deflation. If it were not for Kemp, with Forbes tagging along, there would not be a political leader in the world calling for a gold target to put a definite end to the cursed deflation. We just hope it doesnít take another, bigger kick in the pants.