FSC/Fed Followup Jude Wanniski May 7, 2004

The immediate response of market commentators to the report of 288,000 new jobs was that it guarantees the Fed will have to raise the funds rate by a quarter point at the June FOMC meeting. This is wonderful news for the real economy, but because we are not on a gold standard, even a tiny increase in the Fed funds rate requires an adjustment in the formula the New York Fed uses to hit the higher target. So just as the economy is growing nicely and requiring more liquidity, the Fed would be supplying less. Dollars become scarce relative to gold, which soon translates into dollars becoming scarce relative to all commodities. The $9 decline in the gold price this morning (to $379) simply adds to the problems in emerging economies, as these are the most heavily weighted to commodity production. Asia has a special problem because China`s currency is tied to the dollar and it is forced to drain liquidity from its banking system to keep pace with the incipient dollar deflation. Worse, Beijing is trying to "cool off" its economy by having state banks deny credit to sectors that have been growing faster than they should. That is, they had been fed by the surplus liquidity forced on state banks while the dollar/yuan/gold price was running up last year.

As you may recall, this is how the 1997 Asian Crisis occurred. The Bank of Thailand inflated the baht in 1996 to keep it tied to the dollar as the dollar/gold price rose. The banking system became awash with liquidity, and banks were forced to lend funds to brick-and-mortar developers, keeping their fingers crossed that the projects would work. When the dollar/gold price decline began in November 1996, the Bank of Thailand had to drain liquidity to keep pace. The Thai economy became illiquid and the brick-and-mortar projects became part of the non-performing loans at the banks. The deflation spread through the region and did not end until currency adjustments corrected the problem, but not without a great deal of pain throughout. What we see now is another whiff of dollar deflation around the world, including Latin American economies, with extra pressures in Asia because of the yuan/dollar link. As I noted yesterday, now is the perfect time for someone in a position of authority to begin noting the decline in the gold price as a signal that the Fed should be holding off fighting inflation at the June FOMC meeting, if indeed deflation is just around the corner.

With regard the corporate tax/FSC replacement bill, which I reported yesterday might have come to a vote in the Senate last night, it now is being hung up again. Chairman Chuck Grassley of Senate Finance said that Sen. Maria Cantwell (D-WA) has put the tax bill "in serious jeopardy" by insisting that the Senate debate immediately and vote on her amendment to extend unemployment benefits for 13 weeks. Grassley will call for a cloture vote Monday, stating that if it fails to get the 60 votes it needs, he would not bring it up again this year. I’d have to think that the administration would find a way around the roadblock and get the bill passed. As The Wall Street Journal made clear today, it has been so loaded up with goodies already that if the cloture vote passes, the vote on final passage would be 90-to-10. If it then can pass the House with Ways and Means Chairman Bill Thomas in charge, it would provide another boost to the economic expansion, and send the dollar/gold price lower. If this is hard to follow, I assure you my head hurts too.

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