Last week Fed Chairman Ben Bernanke said the Federal Open Market Committee would be “vigilant to ensure that the recent pattern of elevated core inflation readings is not sustained.” Before his statement, fed funds futures put a 50 percent likelihood of a rate increase at the end of June. But after his comments the market odds of a rate hike rose to 84 percent.
In the past week, the dollar price of gold has fallen 6 percent. Was the presumption of a vigilant Fed behind gold’s fall, or was the death of Abu Musab al-Zarqawi (not to mention an easing of Iran tensions) a bigger factor in making investors more eager to hold dollars? Time will tell, but historically hikes in short-term interest rates haven’t halted commodity-price increases, while the lowering of borrowing costs has often occurred alongside falling commodity prices. Is there a correlation here, or is the rate mechanism overrated in general?
Looked at in retrospect, did the 1 percent federal funds rate of a few years back really deliver us from deflation, or was it a combination of 9/11, steel and lumber tariffs, and anti-growth legislation such as Sarbanes-Oxley that made holding dollars less desirable? During the summer of 2001 — in the months before 9/11 — the dollar was strengthening versus gold as the Fed was cutting rates.
A frequent refrain today is that at 5 percent the Fed is not tight, but simply less loose than it was before. Maybe. But if at 1 percent the Fed was too loose, it’s seemingly safe to say that when the funds rate rose to 2, 3, and 4 percent, and now 5 percent, that money would have been tighter. This makes intuitive sense, but the dollar’s fall (and gold’s rise) accelerated after the rate hikes began — with gold up 50 percent since the Fed started to move rates upward.
Is there a Laffer curve component to all this? Writing in the early 1980s, economists Arthur Laffer, Charles Kadlec, and Victor Canto alluded to such a possibility, noting that rate hikes “represent an increase in the effective tax rate on the activity levels of Federal Reserve member banks.” Rate increases back then “undermined the utility of the dollar as an intermediary currency,” meaning rate hikes “diminished demand for dollars,” which was itself inflationary. Though yields on 3-month Treasury bills reached 16 percent in 1981, the rate of inflation rose substantially.
When marginal tax rates rise to confiscatory levels, big incomes tend to disappear as incentives increase to hide one’s income, work less, or not work at all. High tax rates do not necessarily lead to high tax revenues, as the Laffer curve shows. Does this same dynamic apply to Fed policy?
In a recent statement, the Fed cited “possible increases in resource utilization” as one justification for its most-recent quarter-point rate hike. Implicit here is that the Fed seeks to slow economic growth to quell inflationary pressures. But just as rising tax rates cause incomes and jobs to disappear, don’t interest-rate machinations used to target economic growth cause the marginal investor in dollar assets to seek safe haven elsewhere? More, as the Fed removes dollar liquidity is there a more-than-commensurate sterilization of Fed action as fleeing investors add to dollar liquidity?
It is said that if the Fed raises interest rates high enough, that the gold price will fall as the dollar strengthens. Perhaps. But high nominal rates in Brazil, Argentina, and Turkey have frequently failed to deliver a strong currency. Interest rates fell in Japan throughout the 1990s, yet the yen continued to strengthen.
But if the fed funds rate is in fact not high enough today, what if our central bank jacked the rate up this month to a monstrous 10 or 15 percent? Presumably the dollar’s value would rise substantially, but this assumes that demand for money wouldn’t change in the face of wildly changing interest-rate policy. Isn’t it just as easy to say that a 15 percent bank rate would lead to a run on the dollar as investors exited an economy being targeted for much slower growth by the central bank? High nominal rates aren’t always indicative of rising currencies, as evidenced by countries around the world that have tried to achieve this through higher rates. The same applies to low nominal rates rarely correlating with cheap money.
It’s also said that if the Fed changed course and used open-market operations to target a lower gold price, that at least in the near-term the fed funds rate would have to rise much higher than its present level of 5 percent. Implicit once again is the assumption that demand for money is stable.
More realistically, a specific gold target set by the Fed would allow investors to do the central bank’s job for it. Indeed, investors would presumably delight in a new stable-dollar regime, and the rush into newly stable greenbacks would arguably drive the dollar’s value up (and gold down) with minimal dollar-extinguishment needed by a central bank suddenly targeting a stable market price.
Importantly, there’s historical evidence supporting the above assumption. In 1978, when the dollar went into freefall, investors around the world sought the relative stability of the Swiss franc. While the quantity of Swiss francs surged, the Swiss price level actually fell due to worldwide demand. The Swiss experience suggests that setting an even-more-stable gold target would be far less painful than is assumed.
Just as the past 1 percent funds rate was arguably trumped by exogenous and endogenous factors — such as terrorism and protectionism — maybe continued protectionist sentiment and geopolitical factors are getting in the way of central bank efforts to tighten today. Many hold that these exogenous and endogenous factors are behind gold’s historically high price. Still, past speeches and op-eds, not to mention recent statements, suggest that new Fed chair Ben Bernanke is not basing rate hikes on the rising gold price.
Though gold is up 6 percent since he took over on January 31, and 31 percent since his nomination was announced, the Fed recently stated that “further policy firming may yet be needed to address inflation risks,” as though $600 gold is not necessarily inflationary, meaning rate hikes or cuts will be data dependent on, and meant to target, economic growth one way or the other.
With the above in mind, it may just be that output-gap assumptions still govern Fed action in such a way that has very little to do with dollar-price stability. With the Fed using the interest-rate mechanism to slow economic growth, and stocks correcting downward in response, maybe there is a Laffer curve component to interest rates — one that has investors seeking shelter from its very actions.
– John Tamny is a writer in Washington, D.C. He can be reached at jtamny@yahoo.com.