Rearview Policy Drift Jude Wanniski February 24, 2004

This morning, the New York Times reported from Hong Kong that with the economy heating up and consumer prices rising by 3.5% in January, China is thinking or raising interest rates to slow things down: “China Ponders Interest Rise as Economy Heats Up.”

The report leaped out at me because of last week’s report that the U.S. consumer price index had edged up 0.5% in January. How can this be? The dollar and the yuan have been joined at the hip for almost ten years. This means the monetary inflation must be identical, with the only reasons they would not be: 1) China measures a different basket of consumer goods than we do or 2) a change in the yuan’s value relative to gold (as a proxy for all commodity prices) ripples through China’s economy faster than a change in the dollar/gold price impacts the broad price indices in the U.S. economy. In either case, when two currencies are identical except for their colors and inscriptions, over time the spreads between their price indices must converge. In this case, because the maturity of China’s debt structure in yuan is much less than ours in dollars, the rise in the yuan price of gold shows up in its CPI faster than it does in ours. China’s consumer basket also is much more heavily weighted toward commodities than ours, and the commodity market is where inflations and deflations begin. 

Why is this crucial in analyzing the financial markets? In Monday’s Wall Street Journal, Jesse Eisinger wrote in his “Ahead of the Tape” column, "The big debate now is whether there is inflation in the economy and somehow the government figures are understating it. Is the Federal Reserve’s clear effort to reflate taking the U.S. economy down a path of more significant problems in the future?" 

What the China CPI signals is that, yes, we can expect the broad price indices in the months ahead to show the kind of increases we saw last week. It is a policy drift that is taking place because the Federal Reserve continues to observe deflation in its rear-view mirror while inflation has been taking place under its nose. This is why the dollar/gold price tumbled $15 on Friday on the news of the 0.5% CPI increase as the market for dollar liquidity tightened, more or less making a political prediction that Greenspan may have to tighten sooner than he expects if this kind of data continues. Gold has crawled back yesterday and today with soothing words from the Fed Chairman about inflation concerns. In a real sense there should be less inflation concern now with gold at the $400 level instead of peeking over $430, as it was six weeks ago when the FOMC took “considerable period” out of its statement, flatly telling the markets that the funds rate would next go up, when inflation showed up in its rear-view mirror. 

To broaden the context that should interest all of us, think back to last June 25 when the Fed last lowered the funds rate, to 1% from 1.25%. They did so just as gold, at $347, was finally getting back to its equilibrium level of $350/oz. (in our model). In a few days it popped over that level and had climbed ever since until the FOMC stopped it. If by magic we were suddenly put on a gold standard on June 25, the Fed would have stopped monkeying with the funds rate and begun tightening by selling T-bills on its market desk in New York. Where would the funds rate have gone once untethered? It probably would not have gone very far in either direction. With the dollar/gold rate fixed at a level satisfying debtors and creditors, it would be plausible to the markets that it could be held against speculative tests. The dollar/euro rate on June 25 was at $1.15/€1 and the yen/dollar rate was ¥118, both very close to their equilibrium points relative to gold. It was the perfect time to fix. 

In the eight months since, the financial markets have done well, especially to the end of 2003 and the early weeks of this year. A little dollar inflation did no harm, as in its early stage it buoyed domestic commodities prices without yet pinching industrials and tech stocks. The Nikkei, which was still dragging a small monetary inflation at ¥118 was able to shed that during this period Yen/gold at ¥43,400 is now just above its 15-year moving average instead of just below at ¥41,000. It is enjoying the difference, with bank loans still underwater in June now popping above the surface. 

What should concern us now, I think, is that as new data are released showing rising prices and economic growth, the Fed will have to explain why it is not raising the funds rate, or begin to raise it by quarter-point increments. As it does, it will encourage the market to accumulate liquidity instead of gold, and the gold price will decline, dragging not only commodity prices in its train, but also nominal equity values. Because some commodity prices still are under equilibrium levels, they would be hit least in the early stages. Technology and other NASDAQ stocks that have ballooned the most during the past year will leak the most, as they already have been doing during the past six weeks. If the Congress then cuts corporate tax rates in the next month, to convert the subsidies of the Foreign Sales Corporation (FSC), there would be new demands for liquidity, and further declines in gold relative to a scarcer dollar. The economy will want to be growing faster, but it will be caught in the Fed’s rear-view mirror. 

At the very least, the price of oil should come down if the dollar/gold price declines. The OPEC countries decided to tighten the spigot when it looked like they were going to be paid in ever-depreciating dollars. As the dollar gets stronger relative to gold, as it did in 1997-1998, oil producers have an incentive to sell more oil for dollars, even to cheat on their OPEC commitments. A declining oil price eventually shows up in the Fed’s rear-view mirror as a smaller producer price index and CPI. 

It gets harder and harder to advise the Fed on just what it should be doing from day to day, trying to manage the dollar without a fixed unit of account. It is no exaggeration to say the Fed is the closest institution we have to the Five-Year-Planning Committee in the Kremlin of the old USSR. Instead of allowing the markets to signal the correct match-up of liquidity supply to liquidity demand, each member of the FOMC reads different tealeaves or chicken entrails. The whole idea of a gold standard, Alexander Hamilton explained to Congress, was to put the market as a whole in charge of the national money instead of relying on a committee. In his arguments to Congress for a gold-based national bank, Hamilton asked: “What nation was ever blessed with a constant succession of upright and wise administrators?” Not this one, at least not lately.

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