Zig-zagging on a Downslope Jude Wanniski April 27, 2005

Over the last year, the argument that has separated Polyconomics from other market research firms has been our unwavering confidence that the current Fed strategy to raise the funds rate in quarter-point increments would be detrimental to both economic growth and the value of the dollar. Of course, most financial pundits have raved about how beneficial rising short rates will be for stabilizing inflation and fostering long-term economic growth. As a result, this popular crowd has been debating how aggressively the Fed should tighten, instead of reconsidering their flawed economic logic. 

Market behavior and economic indicators since the beginning of this rate hike cycle are proving that perhaps the Fed prescription has been actually bad medicine. Eurodollar futures since March 31, 2004 began pricing in a prolonged period of rate hikes by the Fed. At the time, the funds rate stood at 1%; the Dow at 10,400; the Nasdaq at 2000; and GDP was growing at a robust 5.0% annual rate. Today, with a funds rate of 2.75%, the Dow hovers around 10,175; the Nasdaq at 1925; and GDP data released tomorrow is expected to come in around 3.5%. 

The market evidence is hardly encouraging that current monetary policy is as beneficial as some believe, especially with the recent fiscal stimulus from tax cuts on capital gains, dividends, and corporate income. If a rising funds rate is as beneficial as its proponents suggest, we would see a bull market in equities as they adjusted to an improving profit and inflation outlook. This belief that the Fed is pursuing the appropriate course is misleading such firms as Bear Stearns to advise their clients that a GDP growth rate of 5.0% is more likely than 2.5%, especially if the Fed reaches a 4.5% funds rate by year-end!

As the economy slows, the inflation outlook slowly worsens. On March 23, a day after the Fed acknowledged the existence of rising inflationary pressures and signaled it would continue course, we argued that the temporary $6 decline in gold to $423 would be short-lived as economic actors during subsequent weeks would demand fewer dollars at the margin in the weaker economic environment. Here is how we put it:

Though the decline in spot gold is a positive signal of reduced excess liquidity today, we expect gold and other inflation signals to resume their upward climb as the slowing economy in the near-term responds by demanding fewer dollars. This has been the pattern since 2003 where information suggesting higher interest rates, such as falling eurodollar futures, leads to temporary dollar strength but is usually followed in a matter of weeks by a reversal, as real economic actors demand less dollar liquidity.

Right on schedule, after trading for a week or two around $425 spot gold had drifted as high as $439 this week as the temporary attractiveness of the dollar at the slightly higher interest rate gave way to the decline in liquidity demand. Soon after March 22 when the Fed announced it would continue raising the funds rate, eurodollar futures moved significantly lower, pricing in a higher funds rate by the end of the year. Rate hawks considered this short-term reaction in gold’s $6 decline as evidence that a higher funds rate would sustainably pull down gold. We argued otherwise because this adjustment in spot gold does not reflect the subsequent effect in the days and weeks ahead that higher rates will have on slowing the economy (which reduces dollar demand) and on banks who will be rushing for cheaper reserves at the open market desk (which increases the supply of dollar liquidity).

Spot gold today fell back to $434, probably in response to the report that crude oil inventories were continuing to climb, knocking $2 bbl off the price and sending the Dow into positive terrain from 71 points down. Remember there are fiscal events that could send gold down, but everywhere we have been keeping our fingers crossed for such positives nothing has yet turned up. During last year’s presidential campaign, Treasury Secretary John Snow had promised small businessmen a thorough review of Sarbanes/Oxley, which imposes crushing burdens on those whose shares are publicly traded. But instead he turned the review over to Bill Donaldson of the SEC, who invited major corporations to comment on SOX and they didn’t make a fuss. The big guys can spend the bucks for serial audits. The only recourse is for the smaller outfits to go private or, as reported this week, go off NASDAQ into the pink sheets, where SOX will not apply as long as the number of shareholders is limited. 

The national economy is still growing, with no signs of moving into negative territory. The durable goods report this morning, the third month in a row showing a decline in orders, almost certainly reflects the sunsetting on January 1 of the accelerated depreciation allowance. The end of a tax cut is a tax increase as far as the real economy is concerned. 

As the equity market continues its zig-zagging on this gentle downslope, it at least suggests to more economists and commentators that there definitely is no irrational exuberance on Wall Street and maybe it’s time to take a breather on further rate hikes. We are seeing more doves fluttering among the rate hawks as we await the deliberations of the FOMC next week, but there are still those on the street and inside the FOMC who insist inflation is creeping back because the Fed has been too timid. What can we tell you, except keep your fingers crossed.