Greenspan, Gold and Oil Jude Wanniski March 18, 1994

I was in Columbus, Ohio, yesterday speaking to the winter conference of the Ohio Oil & Gas Association, a dispirited group of Buckeye wildcatters. The question on every mind was: What is going to happen to the price of oil? At $14-$15 a barrel, which has been the range of West Texas crude lately, the independents across the oil patch are badly hurt and praying for relief. I pointed out to them that with the price of gold at $385, the traditional relationship between black gold and yellow gold would point to a oil price of $22-$26 somewhere down the line. The price of oil should be higher at the end of the year, I said, as this traditional relationship reasserts itself. Why, though, is it so out of whack, gold and oil moving in opposite directions?

The chief reason, I suggested, is that global oil producers during the last several years had reckoned on a world economy that by 1993-94 would be growing instead of stagnating. They thus had made aggregate decisions to sell more oil than the roughly 67 million bbl./day that the world is now actually consuming, and in order to pay their aggregate bills they have to sell that oil, which drives down the price. That's part of it. The price of oil, I explained to the 600 oilmen, is based on expectations like all prices. At $14, the oil price is at the exact balance between people who believe it will go lower and people who believe it will go higher. It can go higher if some producers decide to put less on the market, but that's not likely. It's more likely that consumers will buy more if they see the world economy improving. In fact, if consumers see some dissipation of the negative clouds now hanging over the world economy, they will buy oil for their depleted inventories in the expectation that oil will be more expensive in the future and they will be able to turn a profit.

The major clouds on the world economy have to do with problems that could be created by President Clinton, I explained. If he gets the United States into a trade war with Japan, which he still seems bent on doing, both the U.S. and Japan will have weaker economies and buy less oil, and so will all of their trading partners. If he patches things up with Japan, but gets into a trade war with the fastest growing economy in the world, by withdrawing Most Favored Nation treatment from China, then he also weakens both economies and all those dependent upon the Asian and North American economies, which means less oil is consumed. (Environmentalists, of course, love global depressions because much less oil is consumed everywhere, and they don't have to go to the trouble of putting oilmen out of business with zany green laws.) My guess was that somehow President Clinton would find a way to skirt these time bombs with our Asian friends, the price of oil rising as these dangers recede. We are extremely encouraged to see the Council on Foreign Relations, often a problem in our book, take virtually a united stand against the State Department position on China. And the professional economists are weighing in against U.S. bashing of Japan, all of which is encouraging.

This brings us to yet another cloud over the world economy that President Clinton and his administration have also helped create. If the demand for U.S. dollars falls and the Federal Reserve does not produce fewer of them, by tightening, the price of gold will again rise. This would indicate another increase in future inflation, over and above the amount suggested by gold's 10% rise from $350, further discouraging the purchase of U.S. notes and bonds, and also increasing the risk to equity capital. Interest rates would rise and stock prices would fall. The U.S. economy would sag and less oil would be consumed. The oil price would fall further, blunting the effects of the monetary inflation on the consumer and producer inflation statistics -- which would again cause President Clinton to announce that inflation is not a problem and that Fed Chairman Alan Greenspan has no reason to tighten. 

This, presumably, was the reason Greenspan was summoned to the White House this morning, in advance of next Tuesday's meeting of the Federal Open Market Committee. All of Wall Street now expects that the Fed will decide at that meeting to raise the fed funds rate another quarter point to 3 1/2%. For Greenspan to be summoned suggests a jawboning against such a move, which caused tremors in the bond market and a $4 rise in the price of gold, to $386, which is higher by $2 than it was when the Fed announced its last quarter-point boost. Greenspan does not have many good options. If he doesn't tighten, he will be making the same mistake he made last fall when gold began its climb from $350, when a little snugging would have done the job. He now risks having the bond market assume he has no ceiling on the gold price, and this will change expectations both for gold and bonds, the price of the former then rising and the price of the latter then falling. 

We had hoped Greenspan by now would have been able to educate the markets a bit more, with the second leg of his Humphrey-Hawkins hearings before the Senate Banking Committee. If he had a chance to indicate that he would not be concerned about either economic growth in the future or higher inflation statistics in 1994-96, as long as the gold price stayed below $385 or so, he could strip a great deal of uncertainty regarding his intentions out of the markets. There is absolutely no reason why the 30-year bond could not be at 5 1/2% sometime this year, so long as Greenspan could create a new set of expectations. The financial press, reflecting market uncertainty, continues to insist that Greenspan may tighten in order to slow down the economy, although he has gone blue in the face denouncing the Phillips Curve. Only the right combination of words and actions will make them believers.

The Whitewater problem at the White House is darkening all the economic clouds on the horizon. Even the Senate Banking hearings have been indefinitely postponed, as Sen. Alphonse D'Amato [R-NY], the ranking Republican, has pulled all staff into Whitewater work. Without the ability to respond to informed questions in open hearings, Greenspan has no handy way of clearing away expensive uncertainties. 

Otherwise, what would I like to see happen next Tuesday? Instead of having the FOMC bump up the fed funds and the discount rate, which doesn't impart enough clear information, it would be better if Greenspan had the authority from the FOMC to establish a de facto ceiling on the gold price. Another isolated quarter-point rise would not serve much purpose. For Greenspan to have the freedom to maneuver would be in the interest of the President as well as the economy, because any increase in the growth rate of the economy will lift the price of oil, which feeds into consumer prices. What's the Fed to do next year and beyond, when it is supposed to be fighting inflation? At that point, deflation only wrecks the economy, lowering the Consumer Price Index via a nationwide going-out-of-business sale.

If the world economy can maneuver past these dangers, we will see a convergence of gold and oil prices, accompanied by strong financial markets. My forecast to the oilmen in Columbus was a rosy one in that regard, which they seemed to appreciate. At least they indicated they had a better understanding of why they are getting beaten up so badly. We hope for less anxious times ahead, but while this lasts it can be fairly sporty, on the order of whitewater rafting, to coin a phrase.