What Next? A Weaker Economy Jude Wanniski July 2, 2004

The abrupt nosedive on Wall Street yesterday was not linked to the Fed’s decision Wednesday to raise the funds rate for the first time in four years. After all, equities did tend up in what remained of the day. The 1.5% decline in equities yesterday and today can only be seen as a delayed reaction, because higher interest rates are seen as being needed to gradually slow down the economy to prevent a re-ignition of inflation. Remember there is a difference between Wall Streeters who are betting on the future of the economy and Main Streeters who are the economy. It is unambiguous that the economic actors on Main Street are being told that the central bank intends to continue raising the funds rate until it reaches some “natural” rate between 3.5% and 4.5%.

What we have seen so far is not calamitous, but as we observe already that there is a hue and cry from the inflation hawks who complain that Greenspan wimped out with only a quarter point hike. The New York Times lead editorial joined in this complaint on Thursday, although it clearly suspects Greenspan of accommodating the re-election interests of President Bush and the GOP by being “measured” in his tactics: “To be responsible, the Fed will have to disregard the calendar and keep raising rates in a presidential election season.” The Times “Market Place” columnist, Gretchen Morgenson, provided the Business Day analytics under a screechy headline, “As Greenspan Chases Inflation, Critics Shout, ‘Faster!’” Morgenson’s analysis aggressively argues that Greenspan has fallen behind the inflation curve and by going slow has prompted the sell-off in the bond market, citing the nearly one-point rise in the 10-year’s yield since March. Meanwhile, Republican backers of the “measured pace” argue that higher rates should persuade the market that the economy really is growing nicely, because longer term rates should climb when there is an increased demand for credit. Hmmm.

We separate ourselves from both arguments. Raising the entire interest-rate schedule by pushing up the overnight rate is not the way to contest inflation. As Jamie Galbraith and I noted in our Washington Times op-ed Tuesday, we know raising interest rates would eventually cause prices to fall, but it is not “sane” to do so by weakening the economy. Of course, if employers face insolvency they will throw their inventories on the market at distress prices, workers faced with unemployment will agree to lower wages and consumers worried about the economic future will buy less. The only two sane ways to contest inflation is to increase the demand for liquidity or to directly reduce its supply when gold and commodity prices indicate there is a surplus. As long as the market knows these are the tools the Fed will use, Wall Streeters and Main Streeters no longer will have to spend some portion of their day worrying about the consequences of monetary policy.

Economic behavior is in large part a matter of expectations. Players in the real economy who are deciding to expand, contract or sit tight with decisions on building inventories for the future economy will tend to be a bit more conservative. At the margin, deals that were about to be concluded Tuesday were put on hold or scrapped on Wednesday. One side effect of such changes in expectations is a decline in the demand for liquidity, which shows up quickly in an increase in the price of gold, as existing liquidity suddenly becomes surplus and is not mopped up by the Fed.

If nothing changes in the period between now and the next Fed meeting in six weeks, in one scenario we might imagine business expectations leading to further declines in liquidity demands and higher and higher gold prices. At $400 gold still is in a range where other prices have only a modest way to go to catch up, and the Fed is not going to get excited with annualized CPI numbers below 2%. If we get to mid-August and gold is moving higher, the numbers that follow might spook the Fed into dropping its measured pace. The inflation hawks would certainly be screeching all the louder.

Then again, things will change in the next six weeks, for better or worse. We have been counting on the corporate tax bill passing before this July 4 break and now hear that it is most unlikely it will pass before Congress breaks July 23 for the Democratic convention. But if the markets can see that the shape of the legislation is promising at the break, it could at least discount its eventual passage to some degree. That would increase demand for liquidity. Because so much of the pressure on the world economy is the result of the geopolitical tensions in the Middle East and the effects on oil pricing, any good news on that front will be welcome. The report of 112,000 new jobs being added to the work force last month when the consensus was expecting 250,000 only adds to the confusion among the inflation hawks. Suppose the price of gold is climbing and the real economy is weakening in the period just ahead. This is now a definite possibility, but how does the Fed react? Does it raise interest rates to fight inflation? Or does the weakening economy widen the “output gap” model some of the Fed governors swear by?

It would be best to reexamine the Fed’s basic operating mechanism. This was the hope that Professor Galbraith and I had when we decided to co-author the op-ed arguing against any interest rate increases. Only when the political establishment realizes matters can only get worse by inviting economic weakness to get out of the fix we are in will it be open to better alternatives. A yield curve of 1.25% at the bottom and 4.6% for the 10-year note is practically as good as it can get. To push funds to 4.5% at the bottom, as Brian Wesbury suggested in his frequent CNBC “Squawk Box” appearances, implies a top above 6% (unless the yield curve inverts as it would on such a recessionary path). Chairman Greenspan is always ready to discuss monetary theory, and would not necessarily disagree with the positions that Galbraith and I have taken. The Fed’s statement on Wednesday indicated some of the governors may have read the op-ed Tuesday morning: “Although incoming inflation data are somewhat elevated, a portion of the increase in recent months appears to have been due to transitory factors.”

Senator John Kerry has not said anything about monetary policy, although some of his surrogates have been making relatively innocuous statements compared to the hawkish comments at The New York Times. All Kerry really has to do is raise questions about the appropriateness of fighting inflation by weakening the economy. A debate would spring up instantly, always with the possibility that it would put the Fed on growth path.

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