Pushing Against the Tide Jude Wanniski March 13, 2002

The flow of cash into Wall Street is trying to hold up equity prices but there is just too much resistance, given the continued ever-present drag of deflation. This is not a cash-flow argument, which we generally dismiss except in the very short term, because the market itself is making the assessment that a recovery is underway in inventory adjustments. It is not yet able to see the end of that process, which will fall well short of the government`s expectation and those who are acting on the bullishness that has accompanied those projections. There are plenty of bears around, but as far as we know we remain alone in our formal deflationary analysis which sees an equity sell-off when expectations of renewed profitability are not realized. The price of gold at $294 is still a drag on pricing power for most goods and services, much less so on commodities, which will climb up slowly as input costs to goods and services, at a time when their final prices must be discounted or fall in order to maintain market share.

Half of the deflationary drag -- from $250 gold to $350 gold -- has been eliminated by the reduced demand for liquidity brought about by the weak economy and the consequent fiscal problems that creates for federal, state and local governments. The other half of the deflationary drag could be reduced in the same way, if all those governments expecting faster growth were forced to raise taxes in all their forms. The new steel tariff is of course a tax increase. Now the Commerce Dept., feeling pressures from the rest of its business constituency, is hinting that other like measures may have to be taken. State and local governments are in the same fix, where it will be difficult for property assessments to be lowered with declines in property values as the deflation grinds away. Maybe income-tax rates will not be raised all over, but user fees will push in that direction, as they are much harder to avoid in the short term. What concerns us most is the possibility that all the chickens come home to roost in a short period rather than one at a time.

There is enough "dead" or "inert" liquidity in the system being held because there is no fear of inflation at the moment. We continue to get questions about why bond yields are so high if we are in a deflation, and our response is that the bond market has to weigh the risks of having that liquidity become active when the Fed has no operating mechanism to drain it off. On the contrary, as oil prices follow gold`s rise and other commodities inch up in train, the Fed will be seeing "inflation signals" before the deflation process has been completed. This may not occur, but it does explain why the bond market is pricing in this risk. It also sees a rise in the interest-rate schedule ahead, given what it knows about the Fed`s behavior in recent years. The range of scenarios is wide and widening further, but we remain totally persuaded that market expectations of rising earnings to catch up with climbing prices of equities will not be realized and the p/e adjustment will go the other way. Corporate officers who are announcing they expect to hit earnings targets this year are  guessing higher than they would be if they understood the drag of monetary deflation. There are, though, some sectors that will do better than others this year, related to where they are in the deflation cycle.