A modest rally on Wall Street, and in Europe and Japan greeted the central banks' decision to prevent the dollar from rising above DM 1.90 and Yen 134. The fact that all major stock and bond markets reacted positively to the dollar's fall underscores the logic of the central banks' maneuver: the Federal Reserve has been forced to back off, at least marginally, from its credit squeeze.
This affirms our confidence in the G-7 mechanisms which have been operating for the past three years. Implicitly, the coordination system introduces an element of the monetary policy we want, namely a standard of value for the dollar. If Fed policy pushes the dollar too high against the Japanese yen and the German mark, the G-7 wheel squeaks, forcing the Fed (and other central banks) to grease it. Whether this occurs through direct action to lower the fed funds rate, or through unsterilized foreign-exchange market intervention, the global effect is identical.
The irony is that global realities force the Fed headlong into the monetary criteria we have recommended all along. Much uncertainty would disappear if it recognized these criteria directly, rather than wait for the next mini-crisis among central banks.
As the Fed's Keynesian staff insists, mounting evidence that the series of rate hikes have begun to damage the economy was a contributing factor to the Fed's caution. A majority of the Board of Governors reportedly opposes further tightening. Nonetheless, it was the action of the central banks following their assembly last Sunday which turned the tide.
The first initiative came, in fact, from Japan on March 16, when its central bank took strong action to undercut speculation on higher interest rates. Germany and France followed suit, averting what threatened to become another twist in the global interest-rate spiral. Japanese stock and bond prices had plunged during the preceding week, as institutions feared that the Bank of Japan would have to match the Fed's rate increases. The Bank of Japan's aggressive action turned the tide within the G-10. In its wake, the Tokyo market surged to new records, and Wall Street began a modest recovery back to the 2300 level on the DJIA.
We have argued that the "inflationary danger" which motivated the interest-rate spiral in the first place is overblown. The stage is set for an impressive bond-market rally, on the next announcement of reassuring inflation numbers.
At the Fed's 75th anniversary dinner in Washington last night, Karl-Otto Poehl, president of the Bundesbank, toasted the Fed governors with a reminder that it is the chief responsibility of central bankers everywhere to maintain price-level stability. Poehl has become an enthusiastic supporter of efforts at the Fed to focus on commodity prices rather than quantity targets. We're hearing more discussion of commodity targets from central bankers than we've picked up in years. Ideas may be ripening.