TRADE BILL UPDATE
Financial markets expressed relief when the Reagan veto was sustained by a squeaker vote. But there's still a significant chance, perhaps 30%, a bill will emerge with RR's signature. Protectionist forces control the House. Speaker Jim Wright, Dan Rostenkowski, the AFL-C1O, and business lobbies are hard at work to get a bill back to RR, but there's enough free-trade clout in the Senate to keep action snarled through the summer. Senator Phil Gramm and others will push amendments to defang the worst provisions, especially transfer of authority in Super 301. The Wall Street Journal today urges VP Bush to intervene on the free trade side and many in Bush's high command agree. Senate Majority Leader Robert Byrd could freeze the schedule until after Labor Day. He can still reopen the vote on RR's veto. Chances of a quick resolution are dim, but thankfully free traders have good cards to play. We're watching to see how the issue is handled at the Ottawa economic summit, our trading partners having a chance to press their concerns on RR. Still, no time to relax.
* * * * *
EXCHANGE RATES AND COMMODITY PRICES
Fed Vice Chairman Manuel Johnson last year proposed three indicators to evaluate the risk of inflation — commodity prices, exchange rates and the yield curve, in that order. How are we doing? Commodity prices have not really been rising as much as some suppose; the dollar is at least steady against the yen and generally rising against the DM; and recent increases in short-term interest rates have been accompanied by lower long-term rates (the yield curve flattened). Three out of three is not bad.
EXCHANGE RATES: Interesting question: Does the foreign exchange market know something that has escaped the global bond market? The dollar has been significantly stronger than the mark since the end of 1987, yet the weaker German currency nonetheless offers lower bond yields. This makes no sense. The Bundesbank has even been selling U.S. T-bills to prevent the dollar from rising. Germany could raise the demand for marks by pursuing better tax policies (such as scrapping the withholding tax on interest, or the tax on stock transfers). Otherwise, the world wants fewer marks, not more dollars.
If the mark continues to slide, future inflation could eventually be a greater problem in Europe than in the U.S. Commodity prices that are only slightly higher in dollars or yen have been rising more rapidly in DM and related currencies. The risk of exchange losses in European assets, and perhaps inflation, suggests that bond yields are too low in Germany and too high in the United States. Any investor who held German bonds this year not only received a low coupon and a capital loss, but also experienced an exchange rate loss as the DM dropped by more than 10% against the dollar. If global investors react to these losses by selling German bonds and buying American, then U.S. yields would fall and German yields rise. Indeed, such switching from DM to dollars would itself add to the mark's exchange risk.
It was quite correct for Germany to run an expansive monetary policy last year, when the demand for that country's currency was strong. But Germany should now be careful not to monetize their budget deficit (which is much larger than the U.S. deficit, relative to GNP). Would appropriate monetary restraint in Germany put upward pressure on U.S. interest rates? On the contrary, it should downward pressure on world interest rates. With the dollar simply prevented from rising against tl mark, by a firm policy in Germany, there could be no sustained inflation in either country, since prices of traded goods and services must be about the same when measured in the same currency (otherwise traders would buy goods where they were cheaper and sell them where they were higher). If German monetary policy is not inflationary, the Fed can ease when the dollar rises against DM.
COMMODITY PRICES: From 1984 to 1987, the IMF's index of non-oil commodity prices fell by 11% in dollars, 35% in pounds, 76% in marks and 80% in yen. In 1988, some cyclical and agricultural commodity prices have recovered a bit, as they had to if commodity-related debts were ever going to be repaid. The commodity index that gets the most attention in the U.S. bond market — the Commodity Research Bureau (CRB) futures index -- gets the least attention at the Fed. That index is heavily weighted toward farm products, and has lately risen almost entirely because of "oilseeds" (mainly soybeans). On May 24, the industrial commodities in the CRB futures were actually down 10% from a year ago! Even the spot prices of CRB foodstuffs were unchanged from January to May. As Fed Governor Wayne Angell puts it, speculators in soybean futures aie "forecasting a drought," since the bean crop could actually get through July without rain. Any futures index is also affected by carrying costs — interest rates — so that raising interest rates to curb commodity prices could well have a perverse effect of increasing futures prices, at least relative to spot prices. If it is true that U.S. bonds and stocks rallied on June 8 because of a little rain in the Midwest (rather than the news that the trade bill veto was sustained, and that Alan Greenspan opposed using a weak dollar as a trade weapon), then prudent bond holders should have expected that rally all along. The soybean pit is right next to the bond pit in the Chicago exchange, but that is the only connection.
Unlike the futures index, the CRB spot index for industrial commodities has hovered around 300 since last September. That index of only 13 commodities includes volatile scrap metals, plus things tallow, hides and rosin; it does not even include lumber, gold or oil.
Research by the Fed staff indicates that the Journal of Commerce (JOC) index of 22 industrial spot commodity prices is a far better leading indicator of inflation pressures. But even the JOC index is volatile, has a low weight (7%) on oil, and has to be looked at for longer-term trends. The Journal of Commerce presents the indexed "smoothed" over 250 working days. On that long-run trend, the annual rate of commodity inflation was below zero until the first week of June, when a weekly jump, particularly in aluminum prices, pushed the average slightly higher than a year ago. However, the index uses aluminum prices from the London Metals Exchange, which are highly speculative and above the futures price. Paine Webber calculates the same JOC index over shorter 6-month spans. On that basis, the JOC index was rising at a 25% annual rate in the Summer of 1987, but only about a 1% rate this spring. Most importantly, nobody has been getting rich by hoarding gold over the past year, which suggests that "fears of inflation" are a matter of rhetoric, not action.
A scenario that few seem to be contemplating is that the U.S. and world economy are sound, facing neither the recession that so many economists expected in February nor the big inflation that became the headline story in May.