An intellectual battle is raging within the supply-side community over the level at which the Federal Reserve should set the fed funds rate. The primary concern is the unrelenting rally in gold, which, without question, is warning monetary-policy makers that inflation is creeping higher, as there is simply too much money in the economy than is being demanded by economic participants. As a result, many supply-siders are calling for the Fed to continue raising short-term interest rates in order to restrain gold’s ascent. But with a gradually weakening economy and inflation strengthening — despite 425 basis points worth of funds rate increases — a sense of urgency should force supply-siders to consider whether the Fed’s interest-rate targeting mechanism has been effective at all.
The evidence suggests that the recent fed funds targeting experiment has wholly failed in effectively restraining money-supply growth in relation to money demand. Attention should instead be focused on calling for the Fed to directly intervene in the open market by selling bonds to drain enough liquidity so as to cause gold to fall back to a non-inflationary level of $400 an ounce.
The argument for raising the funds rate presupposes that when the Fed moves this target above the market’s overnight rate of interest, it must engage in open-market operations to enforce that target against market forces. It is then assumed that the Fed sells bonds at below-market prices to the banking system, and thus drains the banking system of cash since banks pay cash for the Fed’s bonds. In reality, however, there has been no meaningful change in the rate of growth of the monetary base ever since the Fed started raising the fed funds rate from 1 percent in June 2004 to 5.25 percent today.
The best proxy for money supply is the Federal Reserve’s balance sheet, the source of all money creation. As the Fed engages in open-market operations, the policy is directly reflected in the asset side of the Fed’s balance sheet — specifically the line item, “reserve bank credit.” During June 2004, reserve bank credit was growing approximately 4.5 percent year-over-year. Since then, reserve bank credit growth has ranged between 4 and 7 percent.
Another important indicator of monetary growth, a broad-based measure of total loans and investments by commercial banks, is currently growing at a 9.5 percent year-over-year rate, an increase from 6.2 percent during June 2004. One simply cannot argue that rising short-term interest rates have been draining the banking system of money supply.
Additionally, the total value of fed funds in the banking system and the size of temporary open-market operations used to manipulate the fed funds market (the market through which the Fed supposedly drains liquidity when banks pay cash for bonds) amounts to approximately $40 billion, a paltry number in relation to the size of the total monetary base. In other words, small open-market operations of the tiny fed funds market are irrelevant given the massive scope of the monetary base.
Clearly, money supply is not being properly managed today, but this is only half of the monetary equation. The Fed also must consider how much money the economy is demanding. When the Fed embarks on raising interest rates, it slows the economy. Since a slower economy requires less money, the Fed is dampening money demand. Consequently, growth during the last year in money of zero maturity (MZM) balances, the most liquid form of money, has been the weakest period of growth within the last 10 years.
This presents an important conundrum when considering whether the Fed should continue raising rates. If the funds rate were raised even higher as some recommend, and money supply growth decelerated (which the evidence shows has not been the case), money demand could decelerate even faster, which would result in a net increase in liquidity and therefore a worsening of inflationary pressures.
Financial markets are perhaps giving the clearest signal that the Fed is doing something wrong. Stocks and bonds would cheer any Fed plans that would successfully stabilize the real value of the dollar. If current rate hikes could truly restrain gold’s rise, equity and bond prices would rally every time futures markets priced in further rate increases by the Fed. This certainly has not been the pattern during the last two years, when any news of further rate hikes has sparked equity- and bond-market sell-offs.
The law of supply and demand for the dollar always determines the value of the dollar measured by the price of gold. Since the Fed began raising the funds rate, the relatively constant growth in money supply and the decline in consumer demand for money have caused gold to rise to $625 from $395, amounting to a near 60 percent depreciation in the real value of the dollar.
The swift run-up in the price of gold during the last two years is dangerously similar to what occurred in the early 1970s, when President Nixon officially severed the Bretton Woods dollar-gold arrangement. Between 1971 and 1974, gold rose from $35 to roughly $160, which in my estimation equated to approximately a 5.2 percent annual inflation rate given the longer-term debt structure of that period. Adjusted for today’s shorter-debt structure, I would consider this to be equivalent to gold going back to $700 by the end of this year.
With the obvious failure of the Fed’s interest-rate targeting mechanism during the last two years, and with no indication that policy makers are questioning its efficacy, the time is now for supply-siders to abandon the notion that some ideal funds rate will produce monetary stability. Instead, the effort should be spent on calling for the Fed to directly target a $400 gold price by selling bonds to immediately drain the excess liquidity flooding the economy.
– Paul Hoffmeister is the chief economist at Bretton Woods Research.