Discount Rate Hike Jude Wanniski August 10, 1988

The half-point boost in the discount rate to 6 1/2% was disappointing, but not terribly surprising. As we observed last week, a sharp split had developed between the Fed governors and the regional Fed presidents, but the Reagan-appointed Fed governors were still in control. Six of the presidents had requested a discount-rate increase as of 8/3, the number jumped to nine by Monday, with indications that 11 of the 12 would be pushing for a half-point by the end of this week. Also critical; it was becoming known that the new Fed governor just confirmed, John LaWare, a Boston Democrat, favored a rate hike, and the split would show up in full force next week at the 8/16 FOMC meeting. Put yourself in the shoes of the Reagan-appointed Fed governors and you can see why they moved unanimously yesterday to concede the half-point. Otherwise, they would have been identified as a "Reagan bloc" more interested in helping George Bush along than in fighting inflation, while the regional presidents, mostly appointed in the Carter years, would be seen as independent and acting on behalf of the national interest.

The division, though, flows from the fact that the Reagan appointees watch gold, commodities, bond yields and exchange rates for inflation signals and the regional presidents watch unemployment rates, growth rates and credit demand for signs of inflation. Frank Morris of the Boston Fed, a ringleader in pushing the Volcker Fed into the 1984 deflation that sent the dollar soaring while commodities collapsed, is back warning that too many people are going to work! Alan Greenspan, with a foot in both camps, was thus of no help in resisting the call of the regionals. The best we can hope for now, with Greenspan having demonstrated his non-partisanship, is that he will lean toward the other Fed governors in the next round, elevating the price of gold and commodities and climbing dollar as clear evidence that enough is enough. The Reagan appointees, having conceded the half-point, are not likely to concede another as their signals now show even smaller signs of inflation. It's not likely we'll see the discount rate trimmed before the elections, November 8. But international pressures, the G-7 accord to stabilize exchange rates, and softer commodities would now bring forth arguments at the Fed to chip away at short rates. This would be welcome.

The half-point rise in and of itself is no big deal, but it's frightening if it's seen as the beginning of a new deflationary trend, which is how it's no doubt being read in Tokyo. The Wall Street Journal's resident monetarist, Lindley Clark Jr., who six months ago was screeching for monetary ease to avert economic decline (and got a tightening instead), today screeches for even higher interest rates to shut off the boom, ("Why Interest Rates Will Keep Rising"). If he is any guide, interest rates will be lower at year's end than they are now. The Fed early this year, remember, went through what seemed like a fine-tuning move, voting to ease on Fed funds in February only to reverse itself in March. While it's not likely, it is at least conceivable that Greenspan has established enough credibility with this move to enable him to reverse himself prior to the elections. He'd have to now establish the objective indicators that would justify such a move, knowing he risks losing several of his fellow governors unless he goes to bat for them for a change. He gets away with this half point, with unpleasant reactions in the financial markets to be sure. But another deflationary step would almost certainly blow up the board.