Thinking Ahead to August Jude Wanniski June 18, 2004

We no longer are worried about the outcome of the Corporate Tax Bill that has been wending its way through Congress for what seems like eternity. When it passed the House yesterday afternoon by 251-178, it became obvious that there is enough support for “something” that would benefit the economy and financial markets when it gets to the President’s desk for signature. The timing, though, has been a disappointment and still is worrisome. Remember that in our “best-case scenario” for monetary policy presented on April 15, the news between then and the June 30 FOMC meeting could not be so rosy about the economy that it would prompt the Fed to begin a cycle of interest-rate increases.

Also critical was that the markets could see progress in the tax bill sufficient to be a sure thing before the Congressional break for the political conventions, a break now scheduled for July 23. If that would happen, there would be additional demands for liquidity from the expanding economy and a continued decline in the dollar/gold price. My best sources on both sides of the aisle indicate less than a 50% chance that the corporate tax bill will be completed by then because the politics are so difficult. This pessimism may be reflected in the $10 jump in the dollar/gold price (to $396/oz.) since the bill passed the House yesterday.

Because the economic news has been rosy and the delayed effects of the inflationary climb that ended in February still are showing up in the price indices, we can practically forget any chance the FOMC will hold its horses on June 30. Mercifully, Fed Chairman Greenspan cut back talk earlier this week of a half-point hike in the funds rate. There really is no need for any increase because the U.S. economy already is in an incipient deflation that will continue as the economy expands on the fuel of last year’s tax cuts and the tax bill coming sometime later this year. There is always the possibility that unless the Fed waits for price indices to calm down, it could raise the funds rate again in August. If it does so, this would cause a decrease in the demand for liquidity that sends the gold price higher.

I frankly do not remember this set of circumstances arising during the last 33 years of floating currencies, and cannot predict how the markets would react. You may note I posted on our web site yesterday’s Wall Street Journal op-ed by Mickey Levy, chief economist of the Bank of America, who argues for a “significantly” higher funds rate by year’s end to smother the inflation that he sees. Levy harkened back to the 1994 interest-rate increases in the funds rate and noted they did not cause anything worse than sideways movement in the equity market. Back then, the Fed pushed against a real inflationary impulse that sent the dollar/ gold price to a peak, but this time the Fed plans to push against an inflationary impulse that has already passed. Passage of the tax bill in the month ahead should confirm the absence of any need for higher interest rates.

The legislative slippage on the tax bill – which by all estimates should have been worked out by April – now means that we have to hope it survives all the traps being laid by its opponents. These are chiefly Democrats in both houses who seem prepared to have the legislation stalled all the way to the November elections, but they also include Midwest Republicans. While I think that they are in error in their opposition, they are not out of line, as they only see at first glance that the bill worked up by Chairman Bill Thomas of House Ways and Means does not sufficiently protect manufacturing jobs from going abroad. There is little chance that the legislation will be killed permanently, because it is a response to the World Trade Organization penalties that mount month-by-month because of the now-illegal aspects of the Foreign Sales Corporation. When it does pass, it will provide solid supply-side impetus to the financial markets and the economy. If you have lost track of what is in the House bill, here is a two-page summary.

There really is no point in trying to imagine what the bill will look like when signed, by one President or another, except to note the fact that both House and Senate versions contain the tax holiday for the U.S. multinationals that we have cited repeatedly as a boon to capital formation. Regardless of when the bill gets to the Oval Office for signature, it will include this provision, particularly since the 5.2% tax rate it offers instead of the 35% rate that would now apply to the roughly $400 billion in profits invested abroad. This means that the budget analysts “score” this as a revenue gainer, which makes it easier to pay for some of the other tax goodies Bill Thomas had to hand out in order to get the bill passed yesterday. Please note the interview Thomas gave to CNBC’s Kudlow and Cramer Wednesday night that discusses the tax bill and the negotiations needed to get to this point. While my bipartisan sources think there is slightly less than 50% chance of getting the bill through by the conventions, my confidence in Thomas puts the chances at slightly more than 50%.

Our April “best case scenario” also has slipped on the geopolitical front, but not by that much. It would be nice if the Iraqi insurgents stopped blowing up the oil pipelines. Oil has come down from its peak following the gold decline, but it would have been helpful if it were now down at $35 instead of $38, where it is held chiefly by continuing geopolitical risk. With the transfer of authority to the “interim government” on June 30, the Iraqi nationalists who are not sufficiently represented in the government will observe how the oil revenues are being handled. If they are being handled properly, we should expect the word to go out to the “insurgents” to stop blowing up the pipelines. This also would help persuade the Fed at its August FOMC meeting that it could coast at 1.25% for the balance of the year.

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