Solid Gold Rate Cuts
Alan Greenspan gets on a bus in a city he doesn't know. He recognizes another passenger – a government worker who collects economic statistics.
The Fed Chairman asks him: "Can you tell me which stop to get off for Policy Street?"
"Sure thing, Mister Greenspan,' comes the reply. "Just watch me carefully and get off two stops before I do."
In real life, Mister Greenspan's problem is even more difficult - there are many statisticians on the bus, and they are constantly hopping on and hopping off. One day GNP is declared to be growing at a comfortable rate and consumer confidence remains high, the next day hard times are spreading from IT and manufacturing to business services. Meanwhile, once-reliable business cycle indicators seem to have lost their prognostic powers.
All this explains why economists and the executive are looking at an ever-broader set of measures. They ought to keep an eye on one of the best early warning signals of the current predicament: gold. Gold is back in fashion in Vogue these days and given the confusing Row of contradictory economic statistics lately, gold ought to be in vogue as an economic indicator as well. Most of us missed gold' signal in late 1999 when it warned of a recession ahead, and we ignore it today at our peril. According to gold, recent Fed actions might have been peachy if undertaken earlier, but they aren't nearly enough now. Until monetary condition returns to neutral relief rallies in the stock market, such as we've seen lately, may well be doomed to fail.
Before you turn the page, mutt e ring something about another nut fixated on the "barbarous relic", I should advise you that what Keynes had in mind when he uttered that famous phrase in the House of Lords in 1944, was strikingly similar to the problem we face today. Then and now, gold was priced too low, because the reference currency was too strong. Then (the 1925 return to the Gold Standard Keynes was referring to) gold's artificial price was a cause of deflationary pressures. Today its market price is a signal of deflationary pressures.
To explain, let 's return to the tired realm of economist jokes. Nobel Laureate Paul Samuelson once quipped the stock market is 200 per cent accurate (or words to that effect) -it had predicted six of the past three recessions. So much for the Fed relying on stock market reactions in gauging their policies. For mere mortals, the other problem with relying on a stock market plunge is that a sell-off is as much the disease as the symptom - who wants to wait that long to get a change in policy? Gold, on the other hand, was giving a decisive signal that the Fed was pursuing an overly tight monetary policy long before your kid's college fund headed south.
The reason is that the international strength of the dollar is one of the key indicators of how tight the money supply is, relative to the global demand for the currency. Unlike constructs such as M2, the Index of Leading Indicators, GNP or the CPI, exchange rates are actual contemporaneous market signals, rather than arithmetic. No indicator is perfect, and no one is suggesting that the Fed handcuff monetary policy to exchange rate movements, but international demand for the dollar must be given due regard. And despite Fed interest rate cuts, the dollar has actually appreciated this year - the US trade deficit has fallen, reducing dollar supply, while both the transaction and precautionary demand for dollars remains high overseas.
When mavens are drawn into a discussion today about whether exchange rates signal an overly tight U.S. monetary policy, they are more likely to say the strong dollar is merely" puzzling" given falling stock markets. You can respond that a strong dollar is perfectly consistent with our current economic straits if monetary policy is overly restrictive. The frequent reply is that exchange rates are ambiguous - a strong dollar may merely tell us that monetary authorities everywhere else in the world are mismanaging their own economies. This view - that Washington knows what it’s doing, but nobody else does - is always popular in the District of Columbia, but is it entirely credible?
This is where gold becomes useful. In September 1999, central hanks came together to develop a more coherent policy toward their conduct in the gold market - the selling and leasing of their own gold reserves. No one argues this was bad policy central bank policy. And it was in the aftermath of this policy development when gold strengthened in most currencies but faltered in ever stronger dollars, that gold signalled Fed tightening had gone too far. As the chart indicates, gold's 1999 rally was negated in U.S. dollars terms by the inexorable rise, from strength to strength, in the US dollar. In other words, the problem lay not with the Japanese economy, the European economy, or with the gold economy (the worldwide community of gold producers, consumers, and intermediaries. The problem lay with US monetary policies.
Measurement problems are another reason to take a look at exchange rates and at gold. The most common measure of dollar strength is the trade-weighted dollar. This primarily reflects the dollar's purchasing power against a few key currencies. Interpreting the strength of the dollar as measured on such an index immediately gets you into judgement calls about the role of other currencies. Also, the world outside the G-7 matters greatly, yet building a meaningful dollar index for emerging markets is a difficult exercise, distorted by hyperinflation, rigged exchange rates, and sudden devaluations. Because gold is produced and consumed in many countries, ill-informed capital markets take a back seat to the judgments of a billion or so souls as to what gold is worth to them today and in the future, in their currency, given their income and savings. As the Asian financial crisis reminded us, the local citizenry's view as Lo the preference of' gold to holding their own currency might sometimes be better than the short-term view of the financial markets.
Unlike artificial indices, gold is a real commodity, which is bought and sold continuously in worldwide markets. It is hard to mismeasure the price of gold, though speculators can run gold up or down a few dollars from equilibrium given sentiment and trading conditions, and gold of course also obeys its own market fundamentals. Such noise from short-term speculators and the long-term trends in fundamentals can be separated From the important monetary signals, Gold is, therefore, a useful monetary policy indicator, driven by a real market's processing of real transactions, not on averages of separate markets imperfectly arbitraged, and reflecting many markets worldwide, not just the most developed.
Some say gold is the clog that no longer barks, but perhaps we 've lost the knack of listening. Gold doesn't have to go up in price to suggest something might be out of kilter. Surreptitious gold sales out of Moscow foretold the collapse of the Soviet Union. Sudden sales of war chest gold in the Middle East now look like leading indicators of the Gulf War. For a year and a half, gold has not so much barked as whimpered. The Federal Reserve should have been listening, and financial pundits should have been reminding them to do so.
As a monetary indicator, gold should be used much as it is used in investment portfolios and adornment - sparingly, as part of a larger ensemble. This, I suspect, is precisely how Alan Greenspan will use gold, and other indicators of global n10n y conditions. And it is why I expect to see further relaxation in monetary policy, irrespective of stock market fluctuations. It is also why I expect the economic recovery to take longer than some expect. The U.S. economy would be better off if' gold were al $300 rather than $260 - not because of' gold's role in the economy, but because it will take more liquidity to get there. Ironically, such a move might not be beneficial to most producers, who operate in otl1cr currencies that will also rise with a falling dollar. As for the final irony - Keynes would be pleased if the Fed listened to gold this time.