Threat to the Dollar
Jude Wanniski
March 25, 1988


The slide in the dollar to 125 yen is being blamed on fears that the trade deficit has not turned around, that consumer spending and personal income are unexpectedly strong and that Japanese insurance companies are unloading dollars they acquired in supporting it earlier in the year. This has weakened the bond market, which in turn caused the mini-meltdown last Thursday in stocks. Or so they say.

In large part, the conclusion is undoubtedly correct: The steady weakening of the dollar in recent weeks from its G-7 midrange target rate of 130 yen to below 126 yen sent bonds skidding. Equities thereupon made a quick adjustment of 43 points in reassessing the risks on whether or not the G-7 range will hold up. Does anyone doubt the markets don't like a weakening dollar from this level of exchange rates and commodities prices?

The problem is in the continued disarray in monetary policy, at Treasury, but mainly at the Fed. Vice Chairman Manuel Johnson is at least over his worst fears about a recession hitting as a result of Monday Meltdown. His CATO speech last month, and others since, indicate he has groped his way back to a price rule from a quick lapse into monetarism. He and Governors Angell and Heller say they are being guided by commodity prices, exchange rates and (to a lesser extent) the yield curve. But they haven't acted as if they were. Alan Greenspan seemed to embrace this framework too, last month, patting Johnson and Angell on the back. His most recent testimony put him back into a GNP-targeting mode, which would be scary if he could assemble a majority of the board, either inflating to lift GNP out of a recession or deflating to shut off economic growth.

The Fed error in February was to ease slightly with the wrong instrument. By adding liquidity when the dollar/yen ratio was dead on the G-7 mid-range, commodity prices steady, and bond spreads looking healthy, the Fed reopened questions about its policy framework: If it would alter its aim after hitting the bulls-eye, something cock-eyed is happening. The most disturbing part of the event was the report of Wayne Angell's vote to ease (after some resistance, we're told). Angell has been most explicit in broadcasting $425 gold as part of his guidance system as being preferable to $450 gold. Yet he voted for additional liquidity, through a 6 1/2% fed funds rate from 6 3/4%, a move he must have known would move policy off the bulls-eye. Gold has steadily drifted back up from $430 to more than $450 and the dollar has inexorably weakened. The Fed could have given the appearance of ease by cutting the discount rate a half point while leaving the liquidity instrument untouched.

The only explanation we can think of is that Angell and the other price-rule people agreed to the adjustment because they didn't want to make a stink about a one-quarter point move and show cleavage at the Fed. The question, as the FOMC meets in a few days: Will they make a stink with the dollar falling, the gold price inching back up, and bond yields rising? Even an eighth of a point up on fed funds, the slightest of snuggings, would do the trick and bolster confidence in the bond markets. Another explicit easing would of course be horrible, leading to a testing of the 120 yen rate, climbing interest rates and another blow to Wall Street. Eventually the price-rule Fed people have to make a stink.