Fedwatch: Getting Nowhere Jude Wanniski & David Gitlitz September 13, 1994

There is nothing we see in the data or the sterile debate about Fed policy that leads us to expect a turnaround in the year-long rout of the 30-year Treasury bond. If anything, Fed policy is bound to slip further on a treadmill that expands the supply of dollars in relation to dollar demand even as it believes it is "tightening" by raising interest rates. As additional data support last month's 0.6% rise in producer prices, bond yields will continue to rise to produce a real return consistent with the rising price level. This morning's report of a more modest 0.3% increase in the consumer price index -- the most lagging of all inflation indicators -- still compounds to a 4.1% annual increase in the cost of living, a jump of 50% on the 2.7% increase seen through July of this year. This surge in statistical inflation is the inevitable consequence of the Federal Reserve's failure to restrain the liquidity excesses first seen a year ago when the gold price climbed 10%, to $385, from $350. As these numbers show up, there is no reason for us to expect the Fed to ignore them, which of course implies continued increases in the fed funds rate which the Fed controls.

Yet if the Fed were inspiring confidence that its policy course would squelch inflation expectations, backward-looking price indicators would be of little consequence, simply a momentary blip on an otherwise clear screen. Market commentary continues to suggest that the Fed will have to continue raising interest rates to keep the economy from growing faster than it is. Fed Chairman Alan Greenspan can make the argument that this is the inflation he worried about in February, when his critics insisted it was all in his imagination. Greenspan's biggest headache, though, is that when he began the "tightening" process, he had argued that inflation expectations can best be seen in three signals -- the gold price, bond yields, and the exchange rate. All three are signaling even more inflation than when he made this observation to Congress, which leaves him and his colleagues with only one defense: Things would have been worse had they not tightened. Now floating around $390, the gold price is moving in the wrong direction, suggesting bond yields over 8% if gold tops $400. Last month's brief respite, with gold below $380 and seeming to trend downward, has been erased by the open market desk's continuing propensity to create, rather than restrain, liquidity.

Last Friday morning, for example, with funds trading below target at 4 11/16%, analysts surveyed by Dow Jones were in agreement that reserves were plentiful and no open market operation was likely. At that point, gold prices were stable at around $390.50 despite the already sharp bond market sell-off in the wake of the PPI report. If anything, the desk should have drained some reserves to meet the funds target. But shortly after 11:30 a.m., the New York desk was in the market purchasing $1.5 billion in customer repos, putting more ink money into the banking system. Our supposition is that the desk wanted to maintain soft reserve conditions to signal that no rate increase was imminent in response to the sharply higher inflation number. Gold prices started to rise almost immediately and by 2 p.m. were bumping against $392. 

In the debate over Fed policy, we have been alone in pointing to the funds-rate targeting procedure as a prime culprit in the Fed's difficulty bringing down inflation expectations. Now we get confirmation from within the Fed itself. In a "Primer On Monetary Policy" published last month by the Federal Reserve Bank of San Francisco, visiting research scholar Carl Walsh points out that during a period when credit demand is rising -- as it is now to finance inventory buildup in anticipation of higher prices -- funds rate targeting "will automatically produce a rise in the supply of reserves as the Fed acts to prevent the funds rate from rising." Walsh was not commenting on current policy or financial conditions, but he contrasts funds rate targeting with direct control of reserves. "Policy that focuses on the quantity of reserves would be less likely to let inflation rise." This is probably right, although a "reserves" target is still too mushy, floating rather than fixed by the markets. In our model, of course, the Fed would be directly "focusing" on the market price of gold to protect dollar purchasing power, adjusting the quantity of reserves accordingly by buying or selling Treasury securities from its portfolio.

Much like the policy course that led to double digit inflation in the 1970s, the desk is now boxed into a rigid operating scheme placing overarching emphasis on pegging an interest rate -- whether or not the target represents an appropriate balance of the supply and demand for dollars. The Fed's larger responsibility to maintain the value of money is being subsumed by these institutional imperatives. We think movement toward a formal dollar-gold link is possible, but probably will not bear fruit until after the next presidential election. In the meantime, the central bank for the world's reserve currency expects that markets can be mollified by a policy process that essentially involves reviewing one interest rate every two months. 

Under the current operating scheme, it's difficult to envision a way out without further significant damage to asset values. The situation is not helped any by the confusion that continues to reign in the public prints, exemplified again on the front page of Monday's New York Times. Under the headline, "Economic Growth Slows from Peak, Renewing Debate," Louis Uchitelle reports on the "perennial debate" among academic economists "over how much economic growth is possible without bringing on damaging inflation." Typical is Lawrence J. Meyer: "The policies are in place to slow down the economy. We just don't know if we have the rates high enough yet to do it." 

The Wall Street Journal editorial page favors gold targeting and provides the only major media outlet for this view. Yet even the Journal remains confused on just what it is the Fed should be doing. In an editorial this morning, on the flap over Fed Vice Chairman Alan Blinder's comments about the Fed's responsibility to fight unemployment as well as inflation, the Journal notes approvingly: "Even Mr. Blinder agrees, after all, with the Fed's 1994 moves to restrain credit." 

The objective, after all, should not be to "restrain credit,"but to remove inflationary expectations that have crept into the markets due to an excess of dollar supply relative to dollar demand. It serves no useful purpose for the Fed to increase the cost of government interest-bearing bills and bonds when the real problem is an excess of non-interest-bearing notes. The Journal and Greenspan are led down the wrong path on the assumption that a higher cost of credit will lead to a higher price for money -- the two are quite different. The price of credit is its interest rate; the price of money is its purchasing power. That is, to get credit you must agree to pay back equivalent goods and services with interest. To get money, you must give up goods and services on the spot (to get my dollar, you sell me your apple). 

The controversy about Blinder's views relative to Greenspan's is a sterile one. Greenspan wants to fight inflation even if "credit restraint" means increasing unemployment in the short run. Blinder wants to fight inflation but only if "credit restraint" does not increase unemployment too much. The debate is not even in the right ballpark, because the higher cost of credit cannot fight inflation, as we have once again observed all year. The Fed cannot create credit or destroy credit, after all. It can only accommodate demands for liquidity, or not. It does so by managing the mix of bonds, bills and non-interest-bearing notes that represent the national debt -- a process over which it has a monopoly. At present, it is using that monopoly power to fix the price of credit instead of the price of money and is getting nowhere in the fight against inflation.