The dollar price of gold rose to $640 Wednesday after Federal Reserve chairman Ben Bernanke told Congress that slower economic growth “should help to limit inflation pressures over time.” Alongside the rise, the fed fund futures market priced in a 65 percent likelihood that the Fed would raise its target rate to 5.5 percent in August. This is down from 84 percent just a few weeks ago, and 90 percent the day before his testimony.
Was the gold market pricing in a more dovish Fed? Did gold’s rise simply reflect greater certainty that Israel would invade Lebanon with ground troops? Or is there more at work here?
Domestically speaking, Bernanke has vacillated quite a bit about his own definition of inflation. He spoke of it in terms of capacity (“slack has been substantially reduced”) on June 5, and then on June 15 in terms of market prices thought to be inflation sensitive (specifically that inflation-indexed Treasuries had “fallen back somewhat in the past month”). On Wednesday, Bernanke resumed his discussion of inflation in terms of growth.
Gold has rallied amidst these vacillations, which could reflect general market incredulity with the Fed. After Bernanke’s most recent testimony, stocks also rallied. Was this an endorsement of the Fed sitting pat amidst inflationary pressures. Was it market relief that the central bank will perhaps not overshoot with too many rate increases?
The freshman Bernanke Fed has generated more questions than answers, and the debate over the Fed’s correct path vis-à-vis interest rates will continue. But given the numerous factors that come into play where paper money is concerned, it’s arguable that the nominal level of interest rates in the U.S. and around the world is to some degree a sideshow where currency strength is concerned. Exogenous and endogenous factors, not to mention the simple credibility of central banks, just might trump the level of interest rates targeted by those central banks.
Former World Bank official William Easterly wrote in The Elusive Quest for Growth that had a $1 billion fortune in 1950s Argentina been kept in Argentine pesos to the end of the 20th century, its value at the later date would have been denominated in pennies sliced into thirteenths. Given Argentina’s monetary history, it would be folly to assume that there exists a “neutral” rate for the peso that would attract peso buyers, and which would anchor inflation expectations. There is very little currency credibility in Argentina, not to mention Brazil, whose Selic rate is presently 15.25 percent.
Japan’s experience with interest-rate targeting brings up different questions. Until last week, the Bank of Japan (BOJ) had targeted a zero percent bank rate for six years. While the yen actually weakened versus the dollar in the aftermath of the BOJ’s recent quarter-point hike, it would be unrealistic to assume that the yen will weaken substantially anytime soon. Misguided protectionist pressure from the U.S. almost assures that the yen will never fall too far against the dollar, and that this will be true irrespective of the nominal rate that the BOJ targets.
The dollar went into freefall in 1979 after the Fed adopted quantity targets, and while high rates were a result of the Fed’s decision, it is also arguable that the rate volatility that resulted from the monetarist experiment would have driven down dollar demand regardless of the level of interest rates. Monetarism wasn’t credible, and as such, neither was the dollar.
Moving to the late 1990s, a falling gold price was strong evidence that the Fed was too tight. Still, the fed funds target was 5.5 percent in April of 1997, and by June of 1999 the rate was 4.75 percent. Over that period gold fell from $350 to $260. Were simple rates the problem, or did the 1997 capital-gains rate cut trump what the Fed was doing as investors flocked to the U.S. and dollar-denominated assets?
Over that same period, currency crises (resulting from the Fed not producing enough money) led to currency devaluations in countries from Thailand to Russia to Brazil. World currency uncertainty also played a role in driving up dollar demand — something that rate targeting (regardless of direction) was ill suited to handle. So even though rates were falling during the time in question, exogenous and endogenous factors clearly outweighed the Fed’s application of the rate mechanism.
The same has arguably applied to monetary policy since 2001. The Fed began cutting rates in January of that year, but the rally in gold really took off after 9/11, with gold continuing its upward movement in the aftermath of steel tariffs and the regulatory monster known as Sarbanes-Oxley. Exogenous and endogenous factors to some degree did the Fed’s job for it four years ago, just as U.S. jawboning of China in recent years along with the continued terror threat has to some degree blunted the presumed impact of rate hikes.
Today, some argue that the dollar is weak because the fed funds rate is not high enough, while some (including this writer) argue that rate hikes only address the supply-side of the dollar equation, with no attention paid to the demand side which logically responds to Fed action.
Is the nominal level of interest rates in fact a sideshow given geopolitical uncertainty, not to mention a Fed chairman who possesses questionable views about what inflation is?
During his confirmation hearings last year, Ben Bernanke explained that he takes a variegated approach to inflation, meaning he looks at numerous indicators to divine whether pricing pressures do or do not exist. With this in mind, is it any wonder that investor interest in the dollar would be lower today? One week Bernanke speaks of inflation in terms of capacity utilization, another week with market prices as his indicator, and still another with the overall economy as his inflation gauge.
This motley approach has led to interest-rate uncertainty, as evidenced by fed fund futures. So long as rates are uncertain, interest in the dollar will be just as shaky. Combined with geopolitical uncertainty, it’s probably not a reach to say that the dollar’s value would be lower today despite the level of the fed funds rate.
Importantly, both sides of the rate debate agree that interest-rate targeting is a crude methodology. Interest-rate targeting merely means the Fed adds or subtracts liquidity to maintain the rate it sets irrespective of dollar demand. Conversely, a gold or commodity target would allow the Fed to float its rate, while using the same open-market operations to add or subtract liquidity with a market price in mind.
Given the various inputs (domestic and worldwide) that impact the dollar’s value, there’s a strong argument for moving in the direction of a commodity price rule. Rather than a question of the “correct” level of interest rates, this is more a question of a mechanism that will correctly factor in demand for a currency that changes all the time.
– John Tamny is a writer in Washington, D.C. He can be reached at email@example.com.