A Troubling Absence of Debate Jude Wanniski August 10, 2005

The most discouraging aspect of the Federal Reserve`s mystical search for the "natural" interest rate on fed funds, which Chairman Alan Greenspan assures us they will know when they get there, is the total absence of debate on their methodology. There are no signs from the minutes of the Fed meetings these 14 months since they began raising the funds rate in quarter-point increments that even one member of the FOMC questions the influence higher rates have on inflation. It is apparently axiomatic that they lower inflation expectations. Worse than no debate inside the Fed, there is none outside the Fed, either in Congress or in the financial press. Our three major newspapers, the NYTimes, the Washington Post, and the Wall Street Journal have each editorialized in support of higher rates, with the <I>Journal</I> the most aggressive in pushing for faster increases.

Yes, Larry Kudlow on CNBC has a daily denunciation of the Fed for raising rates, as he did again last night when the FOMC took funds to 3.5%. His complaint, though, is not against methodology, but on his belief that the Fed has found the right rate to balance unemployment and inflation and it should now cease and desist. In the Fed`s favor, it is required by Congress to hit those two targets with only one arrow. Legislation directing the Fed to only aim at price stability has been gathering dust for decades and would quickly pass if Greenspan said it would be a good thing, but he remains mum.

Congress of course is also mum on the subject. No member of the House or Senate is capable or confident of arguing that a higher rate that in any way weakens the economy contributes to inflation, not the other way around. Polyconomics is virtually the only voice in the wilderness making the argument throughout the Fed`s experiment, which is all it has been, that its quarter-point hikes have been increasing the inflation pressures within the system.

We`ve also warned throughout about the danger of throwing more inflation fuel on the fire as it takes note of the inflation it has caused by previous rate hikes. On CNBC "Squawk Box" Monday, we hear John Ryding of Bear Stearns argue that the Fed has been behind the curve in raising funds so slowly, but that when it gets the rate to where he thinks it should be, 5% or so, inflation expectations will be broken and the price of gold will come tumbling down!!  Ryding is clearly thinking of higher overnight rates inducing a slowdown likened to an inventory recession, with the 10-year note climbing in a way that it has not in the "conundrum period." The idea is that mortgage rates will follow and this will burst the alleged "housing bubble."

The widespread assumption not being debated anywhere is that a higher funds rate will decrease the supply of "money," and thus put less upward pressure on commodities and wages. If there has been anyone on the FOMC raising the possibility that a higher funds rate decreases the demand for money, there is no evidence of him or her. Yet over the 14-month period in question, since funds traded at 1%, both the supply of monetary liquidity has increased steadily and the demand for money has been in steady decline. We not only argued this process was inevitable, but that other things being equal, it would be accompanied by a rise in the price of gold, a sure sign of fresh inflation.

Where Bear Stearns and others in that camp look at the monetary aggregates as evidence the "money supply" has been growing more slowly, we look instead at Reserve Bank Credit (RBC), which has been expanding throughout, from $752 billion to the current $793 billion. RBC could not climb if the Fed were not monetizing debt, thus expanding the asset side of its balance sheet. At the same time, "money with zero maturity" (MZM), the best gauge of the demand for money, has been growing much more slowly. Given this combination of supply and demand factors, we could not expect the dollar/gold price to do anything but climb, which it has, to $436 from $398 when the experiment began. Gold would have climbed much higher if not for the positive signs from the Bush administration and GOP Congress that they remain determined to pursue pension and tax reforms this year. If these materialize even in compromised form, we could see gold decline further as money demand increases. This would help bring oil back below $60 bbl and the 10-year note below 4.25%.

With this positive scenario, we would be unlikely to see the Bear Stearns scenario of a 5% funds rate, which would sharply invert the yield curve. The positive response to yesterday`s Fed statement in the bond market and with Eurodollar futures is a sure sign the markets see a dovish tone developing. The only new phrase in the statement, about "core inflation" being under control, might have done it. We will know much more in three weeks when the minutes are released, but whatever is in the works made Wall Street`s equity markets dizzy yesterday and today.

Another point we take in favor of our analysis was the reactions in British markets to the Bank of England`s August 4 quarter-point DROP in its bank rate, to 4.50%. Since then, the British pound in gold terms has strengthened from just under 246 pounds per gold ounce to 243.27 today. Since August 4, the pound has strengthened against the dollar as well. On August 4th, the pound traded at 1.780 dollars per pound. Today it trades at 1.794 dollars per pound. On the surface, it might appear the U.K.`s yield curve has been inverted for the last year with no ill-effects on its stock market or economic growth, but the Bank`s benchmark repurchase rate is a posted, administered rate, the lowest rate it is willing to lend against gilt-edged commercial paper. Those in need of cash with eligible paper can shop the private banks for better rates if they can. The funds rate, which is targeted, not administered, requires the Fed to add or subtract liquidity, with entirely different consequences for debtors and creditors, inflation or deflation. That`s why an inverted yield curve is much more ominous when it happens here, than in the U.K.

I do expect more discussion on monetary methodology in the weeks ahead, perhaps signs of debate creeping into the Fed minutes or in comments out of the administration. I do send most members of the FOMC these client letters, at no charge, and have indications from some members that they are at least reading them.