More Errors at the Fed Treadmill
Jude Wanniski
May 20, 1994


The bond market slide today is discouraging testimony to the continued failure of the Fed to regain control of inflationary expectations, which is what the last three month's exercise in futility was supposed to be all about. For a while, the market seemed to be deciding that the Fed's Tuesday half-point move of the fed funds rate to 4.25% was really, truly, its last in this particular series. What the market wants to see is a Fed intervention that actually drains reserves from the system, which would be a clear sign that the Fed "tightening" of short rates has passed its peak and a genuine tightening of reserves can take place. This would be accompanied by a slide in the price of gold. 

The long bond did perk up yesterday afternoon when funds traded a sixteenth below the 4.25% target, offering the Fed a clear shot at draining reserves to close that sixteenth gap. Bonds dropped back this morning during speculation that the Fed's open market desk in New York would pass this golden opportunity. Pass it did, and gold climbed more than $3. As far as we can tell, the desk has not drained reserves a single time since Fed Chairman Alan Greenspan began this so-called tightening process in early February. Quite the contrary: every time a gap of a sixteenth showed up on the other end, the desk added reserve to close it. The bond market chatter excuses the desk for this pass, on the grounds that repos will be unwinding next week, which means the Fed would have to add reserves to accommodate, and if they drain reserves now, they have to do that much more. Yak, yak. This is discouraging stuff. All it means is that at the very first opportunity the Fed has had to slow the flow of liquidity to the system, within its operating procedures, it lets it go by!! What's going on here?

Sadly, Greenspan can only be on a Phillips Curve. As much as he has insisted he is not, to Congress and to the markets, there is no other logical explanation for his behavior. We, of course, exclude the illogical possibility that he wants to see the value of government bonds decline, as they have during the process. Indeed, bonds were socked again this afternoon, when the wires carried a May 13 letter Greenspan wrote to Sen. Byron Dorgan [D-ND] trying to explain away his recent errors of monetary policy with this choice bit of reasoning, which would have us believe he has actually saved us from even worse slaughter in the bond market: "To be sure, long-term interest rates moved up far more than we would have anticipated early this year. We had originally expected long-term interest rates to move a little higher temporarily as we tightened. The sharp jump actually experienced, in my judgment, is accounted for by a dramatic rise in market expectations of economic growth and, perhaps, associated concerns about future inflation. Given the sharp change in market perceptions of economic conditions, longer-term rates eventually would have increased nearly the same -- or perhaps even by more -- had the Federal Reserve done nothing so far this year." (Emphasis added.) The letter was released this afternoon by the Fed, which tells me that Greenspan wants this view to circulate.

In trying to explain this arcane business to politicians, I suggest it is similar to what would happen if everyone expected that sometime in the next several days the price of gasoline would rise by 50 cents a gallon. Motorists would top up their tanks every time they were down a quarter, and gasoline inventories would drop at gas stations, which would call suppliers for replenishment. Only when expectations of rising prices ended would motorists return to normal gasoline purchases. And if central suppliers signaled an imminent lowering of prices, motorists would let their tanks run down to near empty. As the Fed has notched up the price of credit, borrowers have transferred funds from the banks to their own accounts, and the Fed, the central supplier, has responded again and again by adding liquidity to the banks. All it can achieve is a weakening of the economy, as the continued expectations of higher inflation decrease the efficiency of capital. This was the point of our letter last week, "Fed on a Treadmill," which appeared in Monday's Wall Street Journal. The same observations have been made independently by other supply-siders, including Alan Reynolds of the Hudson Institute, Art Laffer, and Lawrence Kudlow. 

My assumption until now has always been that Greenspan's primary objective is to increase the value of government bonds, an objective he had been achieving until last October, when things began to go awry. If the value of government bonds is, as we both agree, largely based on the market's estimation of their purchasing power (as the government does not explicitly default on bonds), then policy has to be guided by some objective measure of inflationary expectations. Here, too, I thought we agreed that the price of gold is the best available measure, as he has told us repeatedly that economic growth is not a measure of inflationary expectations and that gold is superior to all other commodities as an inflation signal. 

The Dorgan letter, the Fed's failure to snug up at noon, and the resumption of the slide in bonds today tells us that Greenspan is trapped in a conceptual cul-de-sac, and at the moment the only thing he seems able to do is try to persuade himself that's where he wanted to be all along. If he wants to get out, there is ultimately only one way: to tell his colleagues, the world, the market, the President, and the Congress what he thinks is the optimal price of gold, and then change the Fed's operating mechanisms to achieve that goal. 

Short of that ideal, the Fed cannot blow any more golden opportunities to drain reserves. Over the weekend, Greenspan should keep his fingers crossed that the markets will give him another chance on Monday, and trade funds below the announced target.