Fedwatch: Another Leap of the Lemmings?
Jude Wanniski
November 3, 1994


The Fed's forex intervention yesterday, to pull the sagging dollar up against the yen, has apparently persuaded even small children that the Greenspan Fed on November 15 will raise the fed funds rate by some drastic amount that will really, really slow this "runaway" economy. Polls indicate 60% of the American people think we are in a recession, and 25% fear a close relative will lose his job within the next year. The stock market is crumbling, long-term interest rates are back to where they were in the Bush recession, and an angry electorate is about to throw the rascals out. Yet the Fed "beige book" says the economy is booming and practically every bond-market wizard on Wall Street, led by the indefatigable Wayne Angell of Bear Stearns, says Greenspan, by God, had better raise short rates by plenty. This morning's Wall Street Journal quotes other seers from J.P. Morgan, Salomon Brothers, DLJ, Citibank in London, to the effect that "The markets will be unfazed by another round of intervention unless the Fed convinces investors it is being sufficiently vigilant in its fight against inflation," as the J.P. Morgan economist in London put it.

Meanwhile, since October 17, the Fed's New York desk has added to the banking system an average of $3.76 billion per day of liquidity in each of seven interventions via repurchase agreements. Only twice was the liquidity addition transacted when fed funds were trading above the 4.75% target. Four times the desk added liquidity when funds were smack on target, and once it added when funds were actually below target! These repos in theory will eventually wash out, although they have been rolling over all year in what amounts to a de facto permanent add. Today, even as the Fed was buying dollars with borrowed yen in the foreign exchange market, it was pumping more dollars into the banks with another repo. Worse yet, we see on the wires that the desk is contemplating a system bill pass -- a bona fide permanent addition to liquidity -- for "seasonal needs." Since the Fed began "tightening" in February, raising the price of credit by pushing up interest rates, it has in fact added roughly $30 billion to the monetary base -- the amount of U.S. national debt that does not pay interest, the amount of "liquidity."

Perhaps the likeliest reason we are alone in our analysis is that our definition of "liquidity" is different than that of the monetarists of Wall Street. This has nothing to do with the "M" monetary aggregates, the statistical tools still used by many of the most influential economists on Wall Street as measures of liquidity. The "money supply" is a hopelessly barren concept, as useful as trying to determine the length of a meter or a yard by adding up the number of yardsticks. Nor can much be told by studying the level of bank reserves as reported on the Fed's balance sheet, although reserves -- which don't pay interest -- are part of the monetary base. The monetary base can be growing for good reasons or for bad. No one can tell without knowing whether the demand for liquid dollars is rising because the dollar is in greater demand because of its greater integrity as a store of value, or because more dollars are needed for transaction purposes to accommodate past inflation. 

Consider, for example, the off-balance sheet report on the dollar accounts of foreign central banks held in custody by the Fed. As of October 26, this amounted to $411 billion, up from $399 billion on September 28, $389 billion on August 31, $376 billion on June 15, and $360 billion on February 2 -- a few days before the Fed began tightening. These are liquid dollars showing up abroad, for one reason or another unwanted by private citizens, acquired by foreign central banks in exchange for their own currencies. With them, the foreign banks then buy U.S. Treasury bills or bonds, held in custody by the Fed. If the foreign central banks were not mopping up this liquidity, willing to hold them as reserve assets, they would be thrown into the forex market, driving down the dollar. One way or the other, they would come back into the U.S. banking system, with the Fed forced to mop them up with interest-bearing bills or bonds out of its portfolio to prevent a dollar crash. If the dollar had not lost value relative to gold and U.S. bonds in the last year, we might expect these dollars to be in circulation abroad, earning seignorage for the U.S. Treasury. At the moment, foreign central banks hold more Treasury paper, $411 billion, than does the Fed itself, $394 billion.

Why is the Fed pushing so much liquidity out the window when it is coming right back in through another of its windows? It is, we think, because the Fed is attempting to manage monetary policy by a mechanical, scientific process -- employing elaborate formulae and computer calculations that make use of the several hundred Ph.D.s charting cash flows. They study the Ms and the Fed's balance sheet and the "runaway economy" in the beige book. Lost in the process is Alexander Hamilton's simple insight that in order to sell government debt at the lowest possible interest rates, you must persuade your creditors that you will not devalue your debt by issuing surplus liquidity. Hamilton understood that you do not study your balance sheet to determine whether or not you have issued surplus liquidity; you can not find the answer there. 

In order to connect its promises with reality, the government has to provide its creditors with a mechanism by which they can signal a surplus in liquidity. Hamilton's nexus was the link between the promise of paper and the reality of gold, as a proxy to represent the purchasing power of the universe of goods and services. If a surplus dollar of non-interest-bearing debt shows up at a bank anywhere in the world, it makes its presence known by demanding gold, a demand that can be met with a bond paying interest. The present irony is that Fed Chairman Alan Greenspan, who may be the most powerful man in the world, understands this Hamiltonian world and its gold-linked currency -- in which the market has all the power and the Fed bureaucracy none -- and approves of it in theory. He is, though, all alone, with not a single voice in the world, except for Polyconomics, urging him to abandon his march toward higher interest rates. We had, of course, hoped that former Fed Gov. Wayne Angell was going to lead the band for gold-price targeting when he left the Fed in February, but instead he has become the leader of the opposition. If the Fed does raise interest rates November 15, perhaps it would be enough to break the back of the economy, which is the only way this can ever come to an end. Our guess is that it would not and that Wall Street would soon be speculating on the next increase in fed funds.

Absent the kind of serious outside support that would enable Greenspan to regain control of monetary policy via gold targeting, there is not much good advice we can offer. In these commentaries and in our private communications with the Fed, we have at least urged that the Fed's New York desk end its treadmill bias toward higher interest rates. If it adds liquidity when it is below target, on target, and above target, what is the world to think? Even genetically inferior bond buyers can interpret this tilt. If the desk were required to add only above target and required to withdraw below target, the market at least would have a neutral vehicle for helping guide the Fed Open Market Committee toward its next move. As it is, we see a continuing, slow march of the lemmings toward the cliff, determined to repeat the errors of 1979-80.