Interpreting Fed Policy Jude Wanniski and Paul Hoffmeister December 15, 2004

As expected, the Fed raised the funds rate a quarter point to 2¼% yesterday and gave no fresh hints about the future. It left market analysts expecting more rate hikes at a measured pace until it gets it somewhere between 3% and 5%, perhaps pausing at one of its next two FOMC meetings to see what happens. None of the relevant markets – stock, bond, commodities – did much. But this across-the-board yawn allowed some commentators to suggest the future march to the as yet unknown “neutral rate” between inflation and employment will be a cakewalk. We remain persuaded that the policy is fundamentally incorrect and will continue to encourage more, not less, inflation.

The most curious interpretation of why the Fed is on the right track came in the lead editorial of yesterday’s Wall Street Journal, “Greenspan’s $40 Oil.”

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What a difference a news leak from the Federal Reserve makes. Ever since this newspaper ran its December 2 page-one article, "Fed View Shifting on Inflation: Rate Rises Likely," the world`s leading indicators of future prices have been heading back down. David Malpass of Bear Stearns points out that gold has since dropped to $434 or so from a peak of $456, oil is back down to $41 a barrel and the dollar has been firmer in currency markets. Amazing how that works: The Fed finally signals that it is going to print fewer dollars, and inflation expectations begin to recede.

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The first thing wrong with the editorial is that the Fed has not been signaling that it is “going to print fewer dollars.” Malpass has only assumed that the Fed would reduce the supply of dollars needed to maintain a higher funds rate. He has been surprised that the doubling of the funds rate since June 30 has been accompanied by a sharp rise in the gold price and a sharp decline in the dollar’s value against forex. But he never said the Fed was signaling that it was going to print fewer dollars. 

The second error in the editorial belongs to both the Journal and to Malpass. The Journal article of December 2 supposedly caused readers to say, “Holy Cow, the Fed is going to stop printing dollars!! We should not only buy gold, but also sell oil!!”  But then they sat around digesting this information until December 8, when gold fell $15 on its way to $434/oz. The idea is ridiculous on its face. Markets do not make such monumental moves based on a dope story in a newspaper quoting unnamed “officials.” And if they did, they would not twiddle their thumbs for a week before calling their brokers. 

What we find is that in the last week of November “Reserve Bank Credit” jumped by $5.7 billion. This is a fairly big number that occurred because the Fed expanded overnight liquidity via $5 billion in repurchase agreements, bringing the total repo number to $33.6 billion. This was a huge addition to liquidity in the banking system and coincided with the sharp rise in the gold price that Malpass and the Journal cited. The Fed reported these numbers in its December 2 statistical release. A week later, in its December 9 release, it reported a $1.4 billion decline in Reserve Bank Credit, which essentially constitutes the total asset side of the Fed’s balance sheet, and which at that point in time was $784 billion. In other words, the Fed was PRINTING money in the period when gold was falling sharply. Only it was not printing it fast enough to offset the unwinding of $5.5 billion in repos that occurred in that week, a stupefyingly high number in such a short period. 

Whatever was going in this two-week period would give us the answer to why gold gyrated so wildly, but it certainly had nothing to do with expectations that the Fed would print fewer dollars. It most certainly had something to do with the Fed having to hit its Fed Funds target of 2%, because the additions to liquidity in late November had pushed the rate to 2.04%, and the subtractions of liquidity when the repurchase agreements unwound in the next few days brought funds to 1.98%. The open-market desk in New York is going to do what it is told to do, which is to get as close to 2% as it can. 

Our basic assumption has been that higher interest rates designed to slow down the economy will cause a decline in the demand for liquidity. Please note the Malpass'  WSJ model does not even bring up “demand.” It defies logic to imagine market participants would regard a weaker economy as reason to demand more liquidity, yet that is what we are supposed to believe during the Fed’s experiment. It is not very easy to isolate a single statistic that charts the demand for liquidity, but by the process of elimination we believe the best is MZM (“money zero maturity”) which tracks money that is readily available in the economy for spending and consumption. During the period of September 2002 to September 2003, year-over-year MZM growth grew steadily around 8%. During the fall of 2003, as fed funds futures began signaling higher rates, MZM growth dropped, averaging 3.9% ever since. While money demand declined, the Fed’s balance sheet began expanding at an even faster pace. 

The rising gold price is clearly reflecting this dynamic and we have no reason to expect further rate hikes will send gold south. It’s back up over $440 this morning, and even if it stays at this level, it will mean an average 3% annual inflation rate over the next decade. It feels good at this early stage, with daily celebrations on Wall Street as the S&P 500 hits highs last seen in August 2001. But gold back then was at $268 and today it is $180 higher. Correcting for implied inflation, in other words, the S&P500 is still not doing so hot. And if the Journal and Bear Stearns have their way, getting funds to 4 ¼% by the end of next year, the Consumer Price Index will be showing the reality of the implied inflation and there will be calls for a 6% funds rate to get ahead of the inflation!

In the NYTimes today, Edmund Andrews says the Fed “still has a long way to go before interest rates are up to a neutral level… Even after the latest rate increase, the ‘real’ fed funds rate is about zero after adjusting for inflation. That is well below any definition of normal or neutral. Historically, the federal funds rate has been about two or three percentage points above the inflation rate.” This is only recent history, though. When there was no inflation during the heyday of the Bretton Woods gold standard, the funds rate was only a point or so above zero.