Golden warning
On Jan. 31, the Federal Reserve Board announced that it was lowering the federal-funds rate and the discount rate by one-quarter of 1%. In making the move, the Fed cited the moderation in economic growth and chose to ignore the warning of gold moving above $400 an ounce. As a consequence, the markets have given the Fed a very unsatisfactory grade for its latest rate cut. In the wake of this rate cut, the price of gold has pushed higher to $415 an ounce, long-term interest rates have moved higher, the yield curve has steepened, and the dollar has slipped against the mark and the yen. In other words, interest rates on bonds went up even though the cost of borrowing money fell. Bond investors said, in effect: Pay me more interest to bribe me to own the bonds.</br></br>A rise in the price of gold is the best signal that we have to indicate that there is diminished confidence about the future purchasing-power reliability of money. The price of gold rises when the most savvy and suspicious investors believe the Fed has become a less reliable guardian of the value of our money. Or they may believe that in our democracy the president or Congress may pressure the Fed to lower interest rates. These suspicious investors would move out of dollars and into gold if they thought that the government was leaning on the Fed to lessen its commitment to price stability.</br></br>Last week's interest rate cut raises questions about whether it might have been a politically motivated deal. It was unusual that the discount rate was cut by only one-quarter of 1% -- you have to go back to 1978 to see such a small change in the discount rate -- and yet six Fed banks (including all five of the banks whose presidents have an Federal Open Market Committee vote) requested the move. Based on minutes from the Dec. 19 FOMC meeting, there were some members who would have preferred to leave rates unchanged and were unsure, after the rate cut at that meeting, what the direction of the next rate move would be. Where were their voices at the January meeting? Remember, the term of Fed Chairman Alan Greenspan runs out March 2, only eight months before the presidential election.</br></br>On Jan. 31, the Fed ignored the warning signal from the 8% rise in the price of gold above the 1995 average. The Fed effectively said that even though there is some move out of dollars into gold, it will declare inflation to be satisfactory and give another small shove toward growth. Since the discount rate announcement, the price of gold has risen $11, to $415 an ounce; 30-year bonds have fallen two points in price, taking the yield up to 6.17% despite economic data that ought to have been favorable for bonds; and the dollar has fallen two yen, to 105 yen. Why was the immediate response to this monetary policy change so adverse?</br></br>1. The rise in the price of gold was ignored by the Fed. Standing pat or doing nothing could have achieved a great deal. The Fed could have demonstrated its concern by leaving the funds rate unchanged at 5.5%. If the Fed had not ignored the signal, the suspicions that led to a preference for gold probably would have abated.