A Best Case Scenario Jude Wanniski April 15, 2004

In a best-case scenario for the financial markets through Election Day, the news reports on the national economy’s expansion cannot be so rosy that they force the hand of the Federal Reserve at its June FOMC meeting. Our analysis led us to forecast correctly that good news this spring would send the dollar price of gold tumbling back toward $400, with a concomitant strengthening of the dollar’s forex value. The market reads rosy news as pushing the Fed toward raising the 1% funds rate sooner rather than later, which would mean liquidity would become scarce relative to gold (in the first instance) and everything else (as all nominal prices adjust).

The reason we would like to see some uncertain economic news show up along with the good is that it may be possible for the Fed to avoid raising the funds rate at all this year. It is now pricing in a 1.75% funds rate by December where it was only forecast 1.25% a week ago, before consumer prices showed the continuing modest uptrend that reflects gold’s rise to $430 at one point earlier this year. Because the Fed still is conducting policy through a rearview mirror, we need time for gold’s retreat to cancel out some of the other incipient inflation if there is to be a June pass on funds as enough members hesitate on a rate hike. There is no theoretical reason for funds to trade higher than 1% if there are sufficient demands from a more productive U.S. economy for liquidity that causes gold to trend downward to its $350 equilibrium point. Raising the funds rate for the wrong reason would bother the market and send gold lower faster and extract a real price from the dollar value of equities. That belongs in a less than best-case scenario.

Certainly, there is some froth in the equity market that developed because of the Fed’s overstaying the course in fighting “deflation.” However, as gold declines and steadies in a proper range, the froth in equities could be replaced simultaneously by solid growth. Note the impact President Robert Parry of the San Francisco Fed, an “inflation hawk,” had on Wall Street when be blathered last week about the possibility of funds going to 3.5% in order to contain inflation in a 2% range. We are glad to see Parry leaving at this time, to be replaced by former Clinton economic advisor Janet Yellen. She is more likely to hold back on premature moves to fight an inflation that has already receded by the growth forces at work.

In this expansionary environment, a 3.5% funds rate would be both deflationary and destructive. In a best-case scenario, funds would remain where they were in 1958, which in some ways was the last completely true gold-standard year of the post-war era. That was when the Eisenhower Administration and a Democratic Congress gridlocked over tax policy, and Ike tried to get the fed to push the economy ahead with easier money. There were only tremors in the forex and bond markets as a result. But that was the last time the yield curve was where it was supposed to be, roughly 1% overnight and 4% for a 25-year bond. If the numbers show up in a way the Fed can keep the markets guessing about a rate hike, without having one, fiscal and monetary policy would be as good as we could expect for what remains of the calendar year. This also will work to the advantage of consumers of oil and gas, as world oil production will climb when producers are offered harder dollars. (If gold falls too far, though, investment in oil and gas would decline, causing other problems for the future.)

In a best-case scenario, though, we would expect Congress to effectively deal with the Foreign Sales Corp. in the time that remains before the political conventions. The tax holiday for multinational overseas profits that would be in any bill for the President’s signature would easily clear more froth from the equity market with solid advances taking over instead. It does appear the Democrats behind Senator Kerry may play the FSC card to prevent action prior to the elections, but that does not yet seem to be a firm one. We keep our fingers crossed that the Senate will produce a bill that can then lead to constructive compromise in the House.

Geopolitical risk remains a concern in any scenario. The level of conflict in Iraq is climbing to higher levels. Religious insurgents now are shooting at coalition forces in addition to bombing convoys, and foreign nationals are being kidnapped and in some cases executed. Note the 2.5% slump on the Nikkei last night before there was news the kidnapped Japanese had been released. There remains a diminished threat to the U.S. homeland, though. The intelligence agencies are now at a high state of alert (where they were vacationing in the months prior to 9/11), so we do not expect a disruption of the U.S. economy to come from that quarter. In a best-case scenario, we would expect to see the continuing transfer of responsibility for Iraq’s political future turned over to UN interlocutors. While this would be a huge defeat for the Pentagon neo-cons who want to call all the shots, political and military, it would be the one shift in the Oval Office that would work clearly against further escalation of anti-American hostilities in Iraq, which by now has brought the religious factions together as Iraqi nationals.

The new wild card in all the scenarios is the situation in Israel, which seems dicier than ever given President Bush’s decision yesterday to give Israeli Prime Minister Ariel Sharon what he asked for, at the expense of the Palestinians. Because this issue automatically spills over into the clash of civilizations underway in Iraq, the best we can expect is that the confluence of forces weakens the Likud Party’s grip and strengthens the Labor Party, where Israeli doves outnumber the hawks. The best analysis that I have seen today on the Bush/Sharon deal was by James Bennet of the New York Times, who is clearly skeptical, but does consider some hopeful signs. I also would suggest that you take a look at the “Memo on the Margin” I posted on my public home page, “Origins of 9-11,” which has gotten more reaction than anything I have posted there in seven years.

There is of course a worst-case scenario, but you can infer from the best-case what that might be. I am not betting on the best case, but I think we can get into its ballpark at least. Presidential election years tend to be better than not.

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