The Monetary Treadmill in Reverse Jude Wanniski January 6, 2001

We have been warning for many months that when the Fed got around to lowering interest rates there would be no noticeable change in the price of gold — and hence no amelioration of the grindingly slow monetary deflation that has been underway since 1997. Today came the rate cut, with Fed Chairman Alan Greenspan slicing the funds rate to 6% from 6.5%, with at least another 50 basis points expected by June. Wall Street of course enjoyed the news and quickly celebrated. So far, though, gold has not moved up, as it must if the deflationary forces dragging on the markets are to be arrested and a painful recession avoided. It will help if we review the mechanisms in place because there appears to be no way for the Fed to essentially devalue the dollar against gold, which means the Bush administration will have to create such a mechanism or the deflation will continue and perhaps worsen.

The economic textbooks assume that when the Fed lowers its fed funds target it will have to add liquidity to the banking system by buying bonds from the banks in its system. Conversely, when the Fed is "fighting inflation," it will raise the funds target and subtract liquidity from the system by selling interest-bearing bonds from its portfolio to withdraw non-interest-bearing liquidity. In actual practice, there is slippage in the process which thwarts the Fed's objective. In late 1993, when the Fed began raising its funds target to combat a perceived inflation — the gold price had risen to $383 from $350 after passage of the Clinton tax increase — we noted that gold was not budging. The higher interest-rate target had so altered the demand for funds that instead of selling bonds to withdraw it, the Fed was adding liquidity in order to hit its target. Our chief economist at the time, David Gitlitz, recollected a Fed paper he had read a dozen years earlier which explained the phenomenon. We dubbed it the "Gitlitz Treadmill," for as fast as Greenspan ran, the price of gold remained stuck in place and other commodity prices inched up in train.

The easiest way I found to explain the treadmill was to compare the Fed’s posture to the market for gasoline. If the government announced its intention to raise the price of gasoline next week, motorists would top off their tanks. Their demand for liquidity would rise. The increase in demand for gas would increase the price before the government reduction and there would have to be additions to the supply to offset the price effects of the motorists’ behavior. What we have now is the reverse treadmill, where the motorists are told the price of gas will be lowered, which causes them to run their tanks on near empty to await the better value. At the time we were arguing directly with Greenspan about the futility of his treadmill, Wayne Angell, who had left the Fed in late 1993 to become chief economist at Bear Stearns, recognized our point. But he said it could be countered by having the Fed raise the funds target A LOT instead of a little, so the markets would conclude the process would soon reverse. Angell never got his big move, but even if he did, it would only have put the Fed back where it started, with gold still at $383. The only reason gold finally began its decline in November 1996, as we noted at the time, was the increase in demand for liquidity engendered by the coming supply-side tax cuts of 1997.

This is exactly what we expect in the year ahead, as the Fed cuts the target rate a little at a time or in big swoops. The banking system will be running near empty on liquidity and there will be no increase in the gold price, which means no relief from the grinding deflation. Here is how, a bit differently, our Mike Darda describes the treadmill:

The demand for ‘funds’ between Federal Reserve Banks is not the same thing as the ‘market’s’ total demand for dollar liquidity. The former is determined by the FRBs that bid for reserves at the end of each business day in order to close their books on target. The bidding activity causes the Fed to buy or sell bonds -- add or subtract liquidity -- in order to keep its fed funds target in place. The latter, of course, is illustrated by the dollar/gold price, the most monetary price in the galaxy of dollar prices. Under its current operating paradigm, the Fed is targeting the price of credit, the fed funds rate, not the price of money, its purchasing power relative to gold. The Fed can alter the BIDDING activity of the FRBs simply by shifting its bias, or by communicating a posture for higher or lower rates.

If the Banks expect lower rates, bidding activity at the current fed funds rate can stall, forcing the Fed to retrieve liquidity in order to hold the fed funds target in place. Conversely, if the FRBs expect rising rates, circa 1993-94, the Fed can end up in a situation in which the Banks bid for more reserves even as rates rise, forcing the Fed to monetize debt to hold the higher target in place. Ergo, the Gitlitz Treadmill. Japan’s experience is probably the most stark case of a ‘reverse treadmill.’ Between 1990 and 1999, the BoJ’s target rate on overnight funds fell from 9% to zero but the expectation of continuously falling rates, and prices, caused banks’ bidding activity to stall -- forcing the Bank of Japan to REDUCE the monetary base even as it cut rates. Yen/gold fell faster than nominal interest rates, forcing a tremendous rise in real interest rates and real debt loads that continues to this day.

The problem could be easily solved here and in Japan if the respective central banks would shift to a price target that would add sufficient liquidity to end the deflation. Without any discussion about the true nature of the problem -- even among most supply-siders -- price adjustments will gradually feed into wages, real property and goods and services. A client asks: “Even haircuts?” Yes. If the price of gold over time determines the general price level, a 20% decline from equilibrium will force a decline of approximately that magnitude. At the end of the process, which could take several years, barbers will have to charge $8 instead of the $10 they get now, on average. This process should not surprise economists as every economics textbook criticizes Britain’s decision to return to the gold standard in 1925 at the pre-war level, citing it as cause of the recession that followed, yet the gold adjustment in sterling was only 10%.

Much of the distress could be alleviated with tax reforms that invite higher real wages; if people can afford to go to barbers instead of cutting their own hair, the barber will be able to charge $9. But if tax changes cause further deflation as the Fed worries about higher wages, pushing gold lower, the problem persists. We will be discussing this problem at our client conference at The Breakers in Palm Beach, March 1-4. Nobel Laureate Robert Mundell will be with us. He still is hoping, he tells me, that the Fed easing, which “it should have done earlier,” will lead to a gold price “substantially above $300.” How nice if Mundell were right. It would end the deflation and even boost the euro relative to the dollar. I’m afraid, though, he is not expecting a treadmill in reverse and may soon realize only a shift to a gold target can save the economy from decline.