Letter to a Client Jude Wanniski June 30, 1994

The following is my response to Bosworth Todd of Todd Investment Advisors, Louisville, Ky., who Tuesday asked me to comment on the decline in bank reserves. It's as clear and detailed a statement on the problems confronting the Federal Reserve and its Chairman Alan Greenspan as I can now manage in advance of next week's critical FOMC meeting. 

"Dear Bos: I'm glad you asked. Yes, I'm aware that Wall Street economists are citing declining bank reserves as a bearish sign, which should be good for lower inflation and bonds. I tried to deal with this puzzle in my Friday piece, Market Blowout, in which I pointed out that the Fed itself is having trouble reconciling the data with the argument that it has not tightened enough. That is, Greenspan can point to the data, which show that since February bank reserves have declined, and this was the intent of the Fed in raising interest rates. My argument is that the Fed should not want the level of bank reserves to decline for the purpose of "fighting inflation," which is the monetarist error that aims to reduce the supply of money via economic weakness. The Fed instead should aim to increase the demand for money, relative to real goods (with gold as the proxy for real goods). This is accomplished on the margin by making base money scarce relative to gold, thus driving down the dollar price of gold. This method attacks the inflation component of interest rates, not the real component. Trying to reduce the level of bank reserves by raising the cost of funds can only weaken the economy, yet the incipient inflation causes banks to try to unload dollars faster -- lending them to borrowers who convert them into real goods, as an inflation hedge. Bank reserves, of course, show up in the data as being lower since February. This tells the Fed that there should be less inflation because of less economic activity. 

"The gold price, though, is exactly where it was in February. What is happening is that the velocity of money has increased, which is another way of saying the demand for it has declined, as it passes from hand to hand at a faster rate because the cost of holding it is higher. Greenspan has been adding base money into the banking system at a record rate, yet bank reserves have been falling, as banks lend at a faster rate to borrowers who use the borrowed funds to buy real goods before they rise in price. The shifting of inventories is being seen in the data as an increase in economic activity, which it is not. It is not easy to see, though, because it is happening very slowly. The monetary aggregates seem to be behaving themselves too, but under the surface, they are moving faster. It will be several months before velocity shows up in the data and we will realize that GNP increases are more nominal than real.

"Here is what the Fed is doing:

"Greenspan wants to get inflation out the economy. The gold price at $385 tells him it is 10% higher than it should be, at $350. He decides to get it down by reducing the supply of money, with bank reserves as his proxy for the money supply. That is, he wishes to see a decline in bank reserves. The FOMC agrees to this policy and turns to the fed funds rate as the policy tool. It announces the funds rate will go to 3.25% from 3%. Upon the announcement, the rate instantly leaps to 3.25%, as the market believes the Fed will change its behavior to make the higher rate effective. That is, because banks need only maintain an average level of reserves within a two-week period, they can front-load by warehousing reserves if they believe the rate will be higher before the two weeks are up. At the higher cost of funds, though, banks have to increase their lending if they are to maintain the same ROI. New borrowers are arriving to make this match, borrowers who wish to borrow in order to buy real goods before prices rise. At the same time, the market observed that the Fed might have to raise the funds rate again, to meet Greenspan's objectives, and the funds rate is bid higher than 3.25%. The open-market desk then adds liquidity to the banking system in order to drive the funds rate down to the target level! Perceiving this error, the market sees the Fed is not taking surplus liquidity out of the system, marks down the price of bonds, and puts up the price of gold. Monetarists don't see any inflation because the Ms are behaving themselves and Greenspan doesn't see any inflation because bank reserves are down. He need only dismiss the gold price as signaling something other than inflation.

"What should Greenspan be doing? He must first accept the idea that gold is serving as the proxy for all real goods and that his failure to drive it down toward $350 means he has failed in his objective. He has to understand what I have written above, or he will attempt again to drive gold down by raising the funds rate in order to shrink bank reserves. 

"How does he target gold? If he wishes to get the gold price to $375 from its present $385 (where it was when he began the tightening), he has to persuade the FOMC to change its operating procedures, to ignore the fed funds rate and ignore the level of bank reserves. The open market desk in New York would be instructed to do what is necessary to get gold to $375. If Greenspan announced the gold target, the FOMC would probably not have to do much to get it there, as the markets, realizing the Fed could drain reserves in order to hit that gold price, would sell gold and buy dollars. If the market wished to test Greenspan's resolve, it would not sell gold to acquire dollars, in which case the open-market desk would have to sell bonds into the open market in order to buy dollars. Once the Fed establishes its credibility at $375, buying or selling bonds to keep the gold price at that level, the markets would do that work for the Fed, and the open market desk would have little to do except buying and selling for customers instead of the banking system. Greenspan knows gold is the best proxy for real goods because its stock is so large relative to its flow, which means only a tiny amount of its total inventory (all the gold ever mined) needs to be traded in order to change its price. If the gold price rises, and the Fed doesn't respond, then the market buys other precious metals in order to unload dollars, then oil. At the tail end of the process, workers who are being paid to produce gold, metals, oil, and all other goods and services, refuse to work unless their real wages are increased. 

"What happens if the Fed targets gold? The demand for dollars rises as does the demand for all dollar financial assets, stocks and bonds. The data will show an increase in the monetary aggregates as well as an increase in the level of bank reserves. Monetarists will scream that the Ms are inflationary, but in six to nine months they will admit that for some reason they did not anticipate, velocity declined. Bank reserves will increase as money velocity declines, as banks no longer have to unload reserves, but can pick and choose carefully from the productive enterprises that are lining up for loans. The Fed will not have to print more base money, because the existing monetary base will now support much more economic activity. Capital becomes more efficient as the integrity of the unit of account is preserved. This is not conjecture. We've been through all this several times at different points during the last 25 years, in this country and in most others.

"How bad is the situation we now face? This is really only a whiff of the British disease. Greenspan wasn't at the Fed when we went through this before. Since 1987, when he arrived, the Fed has been killing germs, holding back the supply of liquidity so long as the gold price was above $350. Greenspan could persuade his fellow governors to lower the funds rate so long as this would be consistent with the level of bank reserves he believed would maintain gold at $350. When gold's price rose last autumn, new demand for liquidity did not chip away at it because the Clinton tax increases were beginning to bite. Greenspan also has argued this point well, that all taxation suppresses economic activity to some degree. At the theoretical level, Greenspan believes everything I've written here. At an operating level, he is a prisoner of the data, the Fed staff, and the political milieu, which discourage him from targeting gold directly.

"In a hyperinflation, we would see all the above happening so quickly that the transmission mechanisms would be obvious. When a worker in Rio de Janeiro is paid on a Friday afternoon, he races across the street to deposit his earnings in an indexed bank account, knowing the value is melting while he runs. The velocity of money is very high. At an earlier stage, before the indexation process is perfected, the smartest workers, seeing an incipient inflation, must convert their earnings into real goods. In Mexico, by the time the third peso devaluation occurred in 1979, we heard of workers rushing to the shopping malls on the announcement of the devaluation, to buy electric appliances. Jewelers were quick to mark up all prices of precious metals and stones immediately. Department stores were tardy in marking up their prices. The last thing you want to buy in an inflation is a tomato, which spoils quickly. The finished good that has more monetary properties than any other is the durable good -- the auto, the fridge, the CD player. At the time people are unloading pesos for goods, the statistics observed by the bureaucrats -- including the head of the central bank -- are showing up as real economic activity. 

"We're now seeing this phase of the process in the numbers, with housing starts up, durable goods orders up, commodity prices up. Inventories are not up because consumers are unloading inflated dollars in order to buy at retail. The economy looks strong and President Clinton is wondering why he isn't getting any credit for it. (Jack Kemp, who understands my arguments, on Sunday's 'Meet the Press' said: 'The economy stinks.') The value of financial assets, which are not tied to contracts and thus can respond immediately to an inflationary impulse, have been hammered all year, predicting a slower economy ahead. The higher cost of capital will erode commerce. And as labor contracts unwind, workers will try to demand restitution, getting wage increases to compensate for the inflation that is underway. Insofar as they are successful, prices of finished goods will rise still further. Insofar as they are not, living standards will decline further.

"If Greenspan were to secretly target gold at, say, $350, and sell bonds in the open market until we got there, what would we see happening in the statistical world? We would see a decline in housing starts, a decline in durable goods, an increase in inventories, an increase in bank reserves, a steady rise in the bond market, and a stock market rally that would diminish as gold approached $350, then resume as the market saw that the Fed had stopped its draining of liquidity and was beginning to add liquidity in order to keep gold from falling below $350. The financial writers would write sagely about how the bond market loves a decline in housing starts and durable goods orders.

"If Greenspan were to openly target gold at $350, the bond market and stock market would boom immediately, but in the statistical world there would be fewer declines in housing starts and durable goods orders, and a slower increase in inventories and the level of bank reserves. This is because the value of equities would rise more dramatically with the advance assurance from Greenspan that gold would be pegged at $350, and would not rise or fall from that point into a new inflation or deflation. Banks would find it easier to discover productive, non-inflationary uses for available funds, which is why the rise in reserves would be slower.

"My example of gasoline prices in Market Blowout last week may now make more sense. Remember, I said if you knew gas prices would rise because of government edict, you would buy more now, and the level of reserves at gas stations would fall, even though the central supplier is adding liquidity to the gas stations during the night at a record pace. The suppliers would read the data and think people were driving like crazy, when in fact they were just buying in advance of the price increases. Likewise, if the government announced a coming price rollback, people would drive just as much, but not stop at gas stations until they were near empty. Gas station owners would see cars on the road, but conclude they were buying their gas elsewhere. Central suppliers, simply observing the statistics, would conclude that all driving had stopped.

"Greenspan, at the central supply point, wants proof in the statistics that this hypothesis is correct. I can't give him the proof in the data because even remotely reliable numbers will not be available for several months. It takes between two and four quarters before velocity numbers are available. It was precisely for this reason that Beryl Sprinkel and other followers of Milton Friedman finally threw in the towel on monetarism, insofar as that meant the targeting of monetary aggregates. You may know how many potatoes there are in the system, but if you don't know how hot they are, you can't guess how fast they are traveling from hand to hand. 

"Hey, you didn't think you'd get five pages when you asked: `Any comment on falling bank reserves?' I hope this does it."

QUESTION FROM AN ARGENTINA CLIENT

Q: If the Federal Reserve is buying bonds, as you point out, why are they not rising in price?

JW: In a literal sense, when the Federal Reserve conducts an open-market operation for the banking system, it is not buying bonds at all, but merely exchanging non-interest bearing debt -- the equivalent of cash money -- for the interest-bearing bonds in the portfolios of the commercial banks. When a private investor buys a government bond, he pays for it with money earned through his own production. When the Fed buys a government bond, it pays for it with "cash" it creates out of thin air, what Professor Robert Mundell many years ago described as "ink money," in that it appears with the stroke of a pen. In common parlance, this is known as "printing money," although most money created by the U.S. government is not printed at all, but created via Fed exchanges of ink money for government bonds. If private investors tried to buy up all the U.S. government debt, bonds would skyrocket in price. This would not be a good sign for the U.S. economy, as it would indicate investors are fleeing the stock market. This is what happened in the Great Depression, when equities collapsed and bonds soared. If the Fed tried to "buy up" all the U.S. debt with its "ink money," which constitutes the monetary base, you can readily see the value of government debt and all dollar assets would collapse. The monetary base would go to roughly $4 trillion from $444 billion.

DOLLAR/INFLATION CORRELATION

Q: Isn't a decline in the dollar's foreign exchange value always inflationary?

JW: No, although this one is. Inflation only occurs when the dollar loses value relative to gold, which for almost three millennia has been the world's primary monetary benchmark against which other metals and paper money have been measured. President Nixon's "floating of the dollar" in 1971 did not suddenly end the 3000-year-old habit of private citizens measuring the performance of their government's money against gold. Governments that depart from gold are punished. Those who depart from it greatly are punished greatly. The dollar's value in foreign exchange tells us nothing more than what it will buy against other paper monies. In a floating rate regime, the overriding factor in currency relationships is the monetary policy pursued independently by individual central banks. In a very real sense, the dollar's exchange rate is the intersection of net errors by the Federal Reserve and foreign central banks in hewing to the gold benchmark. Prior to its recent plunge, the dollar had already declined substantially against both the yen and Deutschemark with no apparent impact on U.S. inflation. That's because, until recently, the dollar's value primarily reflected the ability of the Greenspan Fed to keep gold steady at $350, while the yen and DM were deflating. The government was rewarded by the bond market with low interest rates. The dollar's decline this year to $385-390 gold was accompanied by decline against the yen, DM and the bond markets of those countries, as they stabilized against gold. The correlations are not precise from day-to-day, because the markets must constantly guess at the direction of government policies, but over weeks and months gold is the overwhelming determinant on currency value.