The explosive rally in gold and commodities coupled with a decline in broad money growth is an unmistakable sign that monetary velocity — the turnover rate of money — is headed higher. This is bullish for 2004 growth. But if it goes too far, inflation risk will follow just as surely as night follows day.
The strength in gold and the softness of the dollar against key foreign currencies makes the Federal Reserve’s policy statement on Tuesday nothing short of perplexing. In it, the Federal Open Market Committee (FOMC) repeated its concern that “an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level.” Translation: there is not one member of the FOMC that is even the slightest bit tuned into forward-looking measures of inflation risk. The days when price-rulers Wayne Angell and Emanuel Johnson used a market-based approach to guide Fed policy have become artifacts of a bygone era. The Fed now is dominated by academic Keynesians who worship at the altar of the Phillips Curve and read from the script of the output gap.
Most supply-siders have welcomed the rally in gold and commodities — the inverse of the falling dollar — as a positive escape valve from an ultra deflationary and increasingly inane Clinton era “strong-dollar policy.” Indeed, top-notch pro-growth tax cuts have been twinned with powerful monetary reflation. The combination in all likelihood will deliver a stunningly robust 2004. While no one wants to rain on the pro-growth parade, it is important to note that a decline in the dollar relative to gold/commodities could go too far. An inflationary error signal would begin to flash red if the dollar falls to or beyond the $400-an-ounce level relative to gold. Since capital-gains taxes are not indexed for inflation, an inflationary dollar fall would raise effective tax rates on capital — reversing some or all of the Bush capital-gains tax cut.
It is true that economic growth increases the need for money, but higher inflation and interest rates will work in the opposite direction, reducing money demand. Specifically, the 50 percent jump in the gold price from its 2001 bottom suggests about a 10 to 12 percentage-point swing in monetary-base velocity over time. This means that even with faster GDP growth, the Fed will need to find a way to tighten up on its balance sheet in order to head off “an unwelcome rise” in core inflationary pressures. In order for the dollar to be protected from an inflationary overshoot successfully, the federal funds interest rate should be decontrolled and allowed to find its own (higher) level while the Fed target manages liquidity directly around something real — like gold.
While a move to a market-based price rule is not likely anytime soon, leaving the targeted funds rate in increasingly negative territory in real terms could be a much worse option than doing nothing at all. One thing that would help would be for Fed Chairman Alan Greenspan to once again mention that he eyes gold as a sensitive price-level indicator. This would give the market some sense of what the Fed wants to accomplish when it changes policy. The market would then help the Fed do its job instead of working against it.
During Greenspan’s first decade as Fed Chairman, he stated publicly that he used gold as an error signal because gold’s stock is so large relative to its flow (i.e., it is a pure signal of dollar demand relative to supply). As such, the gold price really represents the future price level discounted to the present. Unfortunately, Greenspan had to make a decision between targeting hard or soft asset prices during the late 1990s. He chose the latter — the stock market — with disastrous results. The good news is that if anyone on earth can come up with the twisted logic and tortured reasoning of ignoring gold during one period while paying homage to it in another, it most surely is Dr. Greenspan.
– Michael T. Darda is the chief economist at Polyconomics, Inc., a supply-side forecasting firm. He welcomes your comments at mdarda@polyconomics.com.