Two Locomotives: A Bull Market Scenario Jude Wanniski October 12, 1994

In 1981, after the Reagan tax cuts passed the Congress and as the economy continued heading toward a deep recession, we found ourselves in rare agreement with Professor James Tobin of Yale. In a letter to The Wall Street Journal, the neo-Keynesian Nobel Laureate sized up Reaganomics in his demand model by comparing it to two locomotives in New Haven hooked up to each other: one (fiscal policy) headed toward New York, the other (monetary policy) headed toward Boston. It won't go anywhere, he correctly predicted. In his demand model, the tax cuts were putting money into people's pockets, but the Federal Reserve, in trying to hit Milton Friedman's "M" targets, was pulling money out of their pockets. 

In the supply model, the reasoning was different, but the results the same: tax cuts were increasing the demand for liquidity, which would show up as expansions of the monetary aggregates -- automatically assumed to be inflationary in the monetarist model. Trying to make the Ms behave, Fed Chairman Paul Volcker kept the flow of liquidity into the system to a trickle. The price of gold fell steadily in this deflationary dollar-scarce environment and the monetary locomotive dragged the economy into the worst recession of the post-WWII era. Recession turned into boom in July 1982, when Volcker abandoned the Ms and pumped liquidity into the system to avert a national banking collapse -- ending the deflation. The locomotives were now headed in the same direction.

In the first two years of the Clinton Administration, these macroeconomic locomotives have also been going in different directions. In 1993, the fiscal engine pulled the economy toward weakness as tax rates were increased and health care legislation threatened tax mandates. The monetary engine, though, pulled the economy toward strength as the Greenspan Fed continued to reduce the risks to capital by keeping policy in a non-inflationary mode. This year, the engines have reversed. The threat of socialized medicine has been lifted from market expectations about the nation's economic future. As the mid-term elections approach, the markets are still expecting strong Republican gains in the House and Senate. Not only would these gains bode well for a market solution to health care reform, they may also translate into a modest capital gains tax cut next year. President Clinton might even invite one in a new attempt at bipartisanship. There is already widespread circulation of a "bidding war" on tax cuts between Republicans and the White House as jockeying begins for the 1996 presidential campaign. In addition, either the Congress will return in a lame-duck session and approve the GATT, or somehow put that vote into 1995, which I think would be better for the U.S. economy and financial markets. In either case, the fiscal engine is also being pushed in the right direction by GATT. 

Overall, the financial markets have to be pleased about the way the fiscal engine is being fired up. Yet the markets cannot discount them into asset values beyond a modest amount until they get closer to realization. If we want to contemplate a really enormous fiscal locomotive on the far horizon we can think of Rep. Dick Armey's flat tax proposal. If it makes it into the 1996 GOP platform and Republicans sweep the White House and Congress in '96, we can do some big-time dreaming about Wall Street financial assets. 

On the other hand, there is the here and now of Federal Reserve policy. As in 1982, it has been pulling against economic growth, but instead of harsh deflation, we have been getting mild inflation. The former crippled debtors, who could not pay their bills and went bankrupt, leaving creditors with staggering write-offs. When the deflation ended, debtors became solvent and their creditors cheered up immensely. The mild inflation raises risks to capital formation, measured by higher interest rates and a higher imputed capital gains tax on all productive assets. When the inflation threat is removed, the monetary risk to capital will be removed, as long as the Fed does not proceed to another harsh deflation. 

If both locomotives were simultaneously headed in the right direction, we would see a repeat of the 1982-87 bull market. The Dow would run to at least 10,000 over that stretch of track and the broader markets would do even better because of the heavier influence of capital gains on the low cap stocks.

How would this happen? The 55-point surge of the DJIA yesterday offers an opportunity for analysis. It did not occur because of the changing horizon of the fiscal risk to capital. There wasn't anything in the news on that account. The reason almost certainly was the signal sent to the capital markets by Fed Chairman Alan Greenspan via The New York Times, which seems to be Greenspan's favorite vehicle for throwing winks and nods to Wall Street. On page one of the business section we found an authoritative report from Keith Bradsher that "Fed officials" indicate there will almost definitely not be another rate hike before the November meeting of the Fed's open-market committee. This story rained cold water on the bear market parade in the bond market, which last week built up considerable momentum with rumors that Greenspan was going to pull the trigger at any moment.

Although I have carefully resisted the impulse to call my old friend Alan Greenspan these critical past several weeks, it remains my best guess that he is doing what he can to get the monetary locomotive back on track. And, that he continues to watch the price of gold as the clearest signal of his progress. The fact that gold threatened $400 and backed away last week, sliding to $390, at least did not happen without Greenspan's attention.

My colleague David Gitlitz and I for months have been watching the Fed the way blind men travel with seeing-eye dogs. It is clear to us that there was a definite intellectual break in the pattern of Fed behavior two weeks ago, when for the first time in a year the Fed drained reserves from the banking system. Based upon the "treadmill" hypothesis that David has developed these last several months, this suggested the possibility that the Fed was being encouraged to slow the flow of cash into the banking system as a means of breaking inflation expectations -- instead of slowing the economy by raising the price of credit. There has been some confusion since, as the bears have been beating the drums for another rate increase, which only keeps the treadmill rolling. Still, we observe the price of gold falling smartly. And Gitlitz finds the rate of change of the increase in the monetary base slowing from its early February baseline in the last several weeks.

Let's put all this together, on worst-case, better-case, and best-case scenarios. In the best case, Greenspan is cleverly pulling in the reins, finding innovative ways to encourage the open-market desk to get stingier than it otherwise would be in adding new cash to the system. This requires more faith in Greenspan than we are prepared to recommend, especially after his Friday speech to the American Banker's Association. In it, Greenspan complained that the banks are lowering their lending standards, handing out cash to bum credit risks. The report distressed us because Greenspan himself is responsible for the banks having a surplus of liquidity, which means they have to push out loans they otherwise would reject. How can Greenspan fail to make this simple connection?

In the better case, which we think more likely now, Greenspan is not even involved in the mechanics of the open-market desk. The desk is instead operating on general guidelines. Thus far, the mechanics have produced the mildly inflationary treadmill process. If the brighter outlook from the fiscal engine now produces an increased demand for dollar liquidity based on genuine reductions in the risk to capital -- instead of inventory accumulation to beat price increases -- the Fed's additions to reserves at the 4.75% target will not be sufficient to keep the price of gold from falling, as dollars on the margin become scarcer than gold. This signals a reduction in inflation expectations, causing fed funds to trade below target as the market no longer expects another tightening of credit on the near horizon. This scenario gets us on a virtuous cycle of the treadmill.

In the worst case, Greenspan decides to go with the news flow that shows the stronger statistical economy that is really built on the inflation of the past year. He not only uses his presumed authority to push up the funds rate on "good news" in advance of the next FOMC meeting in November, but also takes a lead at the FOMC in arguing for a sharper run-up in rates to beat down economic growth. This is the least likely of the three scenarios, especially now that he has apparently signaled his intent to stand pat for the next month. Finally, if the mid-term elections prove disappointing for the GOP and our fiscal locomotive, we would have to ponder the bear market scenario again.