The Wrong Way to Tighten -- Or Ease
Jude Wanniski
October 22, 1998


Memo To: Fellow Supply-Siders
From: Jude Wanniski
Re: Greenspan Doesn't Get It

We have been warning our clients for several months that the world's central economic problem is the dollar monetary deflation characterized by the two-year decline in gold and other commodity prices and that it couldn't be cured by lowering interest rates. Many of our long-time supply-side friends and allies in the economic wars agreed with us back in 1994 when the problem was a rise in the price of gold and the inflation that followed. On May 16, 1994, The WSJournal editorial page carried a short op-ed that I wrote about why a higher interest rate should not be confused with "tightening" by the Federal Reserve. Alas, when it comes time for the Fed to "ease," we run into the same problem, but most of you my supply-side comrades ~ look the other way. Please re-read the 1994 WSJ piece and tell me where I, or you, have gotten off track:

The Wrong Way to Tighten: Repeating an Old Error
by Jude Wanniski

On this page recently, various economists have argued that the Federal Reserve might continue "tightening" by raising the federal funds rate by 25 or 50 basis points either to put the economy on a slower noninflationary growth path (author David Hale) or until the price of gold falls (author Lawrence Kudlow). The recommendations are incorrect and self-defeating.

If the objective is to reduce inflationary expectations, the gold argument is correct in that the price of gold is the most sensitive inflationary signal, as Federal Reserve Chairman Alan Greenspan told Congress in February. The Fed should then put aside the federal funds target, which has nothing to do with inflation, and target gold directly. That is, the Fed should instruct its open-market desk in New York to sell bonds, draining reserves from the banking system, until gold falls to $350 ~ or wherever Mr. Greenspan would again feel gold is no longer signaling future inflation. I tend to agree with the $350 suggested by Mr. Kudlow, as my observations over the past several years suggest bondholders seem happiest at this level.
Three times this year the Fed has notched up the funds rate by 25 basis points, and it now stands at 3.75%. When the process began, gold was at about $385, and it is still at $385. Obviously, the Fed is making no headway. During the period of supposed "tightening," Federal Reserve credit has been expanding at a rate of more than 12% on an annualized basis. The reason is that with each notch, the demand for bank reserves has also notched up. This is because borrowers, expecting the rate to go even higher, bid for funds at the lower rate. The Fed then has to increase the flow of funds to the banking system, printing more money, to keep the funds rate down.

As a result, there is no tightening. In a paper delivered a decade ago, the late Fed Governor Henry Wallich noted that fed funds targeting was entirely driven by demand for reserves. This can permit inflationary pressure to continue building in the system at any given level of rates. Currently, the Fed has not slowed the flow of liquidity a bit in this self-defeating operating process. Worse, bondholders must now worry that when the higher interest rates slow the economy, the Fed will be adding cash at an even faster rate, attempting to spur it on. In some ways, Mr. Greenspan is repeating the mistakes of Fed Chairmen Arthur Burns and G. William Miller.

If gold were targeted directly, the federal funds rate would float along with all other interest rates. If might rise somewhat, as the Fed slowed the flow of reserves to the banking system, but not because of expectations that it would move higher. As long as the market understood that the Fed would again increase reserves when gold fell below $350 and would not continue to deflate, long-term interest rates would fall along with inflationary expectations. And no harm would be done to the economy.

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Four years later, my old friends, what we all seemed to agree upon in 1994 went by the boards. As soon as the gold price began falling in late 1994 as the demand for reserves increased, you guys all ran for the hills, suddenly deciding that $350 gold was too high. Now you are chattering about lower interest rates to ease money, when it should be obvious that lower interest rates do not increase liquidity beyond the demand for reserves. You all should join hands and announce that you goofed, and join Jack Kemp in arguing for sufficient surplus liquidity to bring gold to at least $325.