Worried about Deflation Jude Wanniski February 20, 2004

The jitters in the stock market today following release of the CPI increase of 0.5% in January is absolutely related to the drop in the dollar/gold price, which fell another $15 today at one point and now is under $400. It is almost certainly headed lower as the markets assume Fed Chairman Alan Greenspan will be unable to maintain the happy talk about inflation being under control that he presented last week to the banking committees of Congress. But maybe he can. It will be hard in any of the various models that the Fed governors use to justify their actions in keeping the funds rate at 1%, when all the numbers coming in are pointing in the direction of higher consumer prices. There may be no escape from a rate hike. Where a benign CPI report today would have permitted Greenspan to "manage expectations," as we suggested earlier this week, today`s report knocks the props out from under the "patience" argument. Greenspan might be able to manage expectations to a degree, but he cannot manage the CPI and other broad price indices. Unless there is some reaction from the Fed, it certainly will open speculation that the governors are playing politics to benefit the administration, stretching every point to push rate hikes past Election Day.

Once the Fed removed those two words "considerable period" from its statement on how long it would leave the funds rate at 1%, it moved to the other side of the slippery slope, which is why we have to worry about another deflation even as Greenspan is forced to worry about an outbreak of inflation. The economy is expanding because of the favorable tax climate and the end of the last monetary deflation, but now that the incipient inflation we have argued began last year when gold moved up over $350 oz is producing the lagged price numbers, it is easy enough to imagine playing the same game all over again. When gold falls in $10 or $15 chunks, it does not take long to get back to $350. This still is where we think gold belongs if inflationary and deflationary trains were to be brought to a joint standstill. However, those nominal dollar prices that have boosted equity values will be yanked out. This really is going to be the first good test we have of Greenspan`s ability to bring the rest of the FOMC along with him as he first attempts to manage these market jitters with some well chosen words.

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